^Ist SeTsfoT } COMMITTEE PRINT
SUMMARY OF H.R. 13270, THE TAX REFORM
ACT OF 1969
(AS PASSED BY THE HOUSE OF
REPRESENTATIVES)
PREPARED BY THE STAFFS
OF THE
JOINT COMMITTEE ON
INTERNAL REVENUE TAXATION
AND THE
COMMITTEE ON FINANCE
(Note. — This document has not been reviewed by the committee.)
AUGUST 18, 1969
Printed for the use of the Committee on Finance
'iM SeTsfoT } COMMITTEE PBINT
SUMMARY OF H.R. 13270, THE TAX REFORM
ACT OF 1969
(AS PASSED BY THE HOUSE OF
REPRESENTATIVES)
PREPARED BY THE STAFFS
OF THE
JOINT COMMITTEE ON
INTERNAL REVENUE TAXATION
AND THE
COMMITTEE ON FINANCE
(Note.— This document has not been reviewed by the committee.)
AUGUST 18, 1969
Printed for the use of the Committee on Finance
U.S. GOVERNMENT PRINTING OFFICE
^-^58 0 WASHINGTON : 1969 JCS-61-69
For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, B.C. 20402 - Price 55 cents
COMMITTEE ON FINANCE
KUSSELL B. LONG, Louisiana, Chairman
CLINTON P. ANDERSON, New Mexico
ALBERT GORE, Tennessee
HERMAN E. TALMADGE, Georgia
EUGENE J. MCCARTHY, Minnesota
VANCE HARTKE, Indiana
J. W. FULBRIGHT, Arljansas
ABRAHAM RIBICOFP, Connecticut
FRED R. HARRIS, Olslalioma
HARRY F. BYRD, Jr., Virginia
Tom Vail, Chief Counsel
Evelyn R. Thompson, Assistant Chief Clerk
JOHN J. WILLIAMS, Delaware
WALLACE F. BENNETT, Utali
CARL T. CURTIS, Nebraska
EVERETT Mckinley DIRKSEN, Illinois
JACK MILLER, Iowa
LEN B. JORDAN, Idaho
PAUL J. FANNIN, Arizona
(II)
CONTENTS
PART I
Outline Summary of Provisions
Page
I. Tax reform provisions 3
II. Extension of surcharge and excises, termination of investment credit,
and certain amortization provisions (contained in H.R. 12290 but
which have not yet passed the Senate, and which are in H.R.
13270) 7
III. Adjustments of tax burden for individuals 7
PART 2
Analysis of Provisions and Arguments For and Against
A. Private foundations 11
1. Tax on investment income 11
2. Prohibitions on self-dealing 12
3. Distributions of income 13
4. Stock ownership limitation 15
5. Limitations on use of assets 16
6. Other limitations 17
7. Disclosure and publicity requirements 18
8. Change of status 19
9. Changes in definitions 21
10. Private operating foundation definition 22
11. Hospitals 23
12. Effective dates 24
B. Other tax-exempt organizations 25
1. The "Clay-Brown" provision or debt-financed property 25
2. Extension of unrelated business income tax to all exempt or-
ganizations .--T-- ^^
3. Taxation of investment income of social, fraternal, and similar
organizations 28
4. Interest, rent, and royalties from controlled corporations. _ — 29
5. Limitation on deductions of nonexempt membership organiza-
tions 29
6. Income from advertising 30
C. Charitable organizations 31
1. 50-percent charitable limitation deduction 31
2. Repeal of the unlimited deduction 32
3. Charitable contributions of appreciated property 33
4. Two-year charitable trust 35
5. Charitable contributions by estates and trusts 36
6. Gifts of the use of property 37
7. Charitable remainder trusts 37
8. Charitable income trust with noncharitable remainders 38
D. Farm losses 39
1. Gains from disposition of property used in farming where farm
losses offset nonf arm income 39
2. Depreciation recapture 41
3. Holding period for livestock 42
4. Hobby losses 42
(in)
IV
Page
E. Limitation on deduction of interest 43
F. Moving expenses 45
G. Limit on tax preferences 47
H. Allocation of deductions. 48
I. Income averaging 50
J. Restricted stock plans 51
K. Other deferred compensation 52
L. Accumulation trusts, multiple trusts, etc 54
M. Multiple corporations 55
N. Corporate mergers 57
1. Disallowance of interest deduction in certain cases 57
2. Limitation on installment sales provision 59
3. Original issue discount 60
4. Convertible indebtedness repurchase premiums 61
O. Stock dividends 62
P. Foreign tax credit 64
Q. Financial institutions 66
1 . Commercial banks — Reserves for losses on loans 66
2. Mutual savings banks, savings and loan associations, etc 67
3. Treatment of bonds held by financial institutions 70
4. Foreign deposits in U.S. banks 71
R. Depreciation allowed regulated industries 72
1. Accelerated depreciation 72
2. Earnings and profits 73
S. Alternative capital gain rate for corporations 75
T. Natural resources 75
1. Percentage depletion 75
2. Mineral production payments 78
3. Mining exploration expenditures 80
4. Treatment processes in the case of oil shale 81
U. Capital gains and losses 81
1. Alternative tax 81
2. Capital losses of individuals 82
3. Collections of letters, memorandums, etc 83
4. Holding period of capital assets 8^
5. Total distributions from qualified pension, etc., plans 85
6. Sales of life estates, etc 87
7. Certain casualty losses under section 1231 88
8. Transfers of franchises 89
V. Real estate depreciation 90
W. Cooperatives 92
X. Subchapter S corporations 94
Y. Tax treatment of State and municipal bonds _ 95
Z. Extension of tax surcharge and excise taxes; termination of investment
credit 96
1. Extension of tax surcharge at 5-percent annual rate for first
half of 1970 96
2. Continuation of excise taxes on communication services and
automobiles 96
3. Repeal of the investment credit -_ 97
4 . Amortization of pollution control facilities 98
5. Amortization of certain railroad rolling stock 99
A A. Adjustment of tax burden for individuals 100
1. Increase in standard deduction 100
2. Low income allowance 101
3. Maximum tax on earned income 102
4. Intermediate tax rates; surviving spouse treatment 103
5. Individual income tax rates 104
6. Collection of income tax at source on wages 105
PART 3
Statistical Material— Tables
^' '^^^.^'^Jf'i^'"! °^ :tax reform with tax relief under H.R. 13270 with Page
modified rate reduction-Calendar year tax liability inq
2. Balancing of tax reform and tax relief-Calendar year ta"x liabifity " " " 1 OQ
3. Individual income tax liability-Tax under present law and arnount'and
S?ve5! ^ ^"^' ''"''"'■ ''^°'°' ^"^ ''^''^ provisions when fuUy
4. Tax relief provisions affectYng [ndiViduals and total" foV alf reYorm an"d ^ ^^
wL^'^'^'''-^^' ^^^"i^^^S individuals, when fully effective bj ad-
_ justed gross income class, 1969 levels > ^y -^^
o. rax reform provisions aflfecting individuals, full year'effect— Bv'ad-
justed gross income class ----___ j'«'^
6. Revenue estimates, tax reform, calendar yVaVfiabUity jl o
T^'L^^blo r^^^^^V'^d^': P'-'^sent law, number made nontaVabYe'byVeii'ef
provisions and number benefiting from rate reduction 113
«. lax burdens under present law, under H.R. 13270, and YercenYtax
change-Married couple with 2 dependents. ' ^ ^ 1 1 -^
J. lax burdens under present law, under H.R. 13270, 'and YerYenY tax
change— Single person under 35... ' percent tax
10. la.x burdens under present law, under H.R. Y327b, YndYercenYtax
change-Single person, 35 and over. . ' ^ ^'''' 1 1 4
11. Effect of H.R. 13270 on fiscal year receipts, igYo'and ignYYYYYY::: 114
PART 1
OUTLINE SUMMARY OF PROVISIONS
(1)
PART 1
OUTLINE SUMMARY OF PROVISIONS
The provisions included in H.E. 13270 can be briefly summarized
as follows:
I. Tax Reform Provisions
1. Private Foundations. — The permissible activities of private foun-
dations desiring to preserve the benefits of tax exemption, as well
as the tax benefits to their contributors, are substantially tightened
to prevent self-dealing between the foundations and their substantial
contributors, to require the distribution of income for charitable
purposes, to limit their holdings of private businesses, to give assur-
ance that their activities are restricted as provided by the exemption
provisions of the tax laws, and to be sure that investments of these
organizations are not jeopardized by financial speculation. In addition,
these private foundations are called upon to make a small contribu-
tion, 7% percent of their investment income, toward the cost of
government.
2. Tax Exempt Organizations^ Generally. — The activities of exempt
organizations generally are limited so that they cannot participate in
debt-financed leaseback operations, wherein they, in effect, share their
exemption with private businesses. Second, the unrelated business
income tax is extended to virtually all tax-exempt organizations not
previously covered by this tax, including churches. Third, the bill
extends the regular corporate tax to the investment income of tax-
exempt organizations set up primarily for the benefit of their members,
such as social clubs, fraternal beneficiary societies, etc.
3. Charitable Contributions. — Charitable contribution deductions
are substantially restructured. The general charitable deduction limi-
tation is increased to 50 percent but the so-called unlimited charitable
deduction is phased out over a 5-year period. The extra tax benefits
derived from charitable contributions of appreciated property, are
restricted in the case of gifts to private foundations, gifts of ordinary
income property, gifts of tangible personal property, gifts of future
interests, and in the case of so-called bargain sales. Also, the 2-year
charitable trust rule is repealed and a number of changes are made
limiting charitable contribution deductions where there are gifts of
the use of property and in the case of charitable remainder and
charitable income trusts.
4. Farm Losses. — The deduction of farm losses is restricted in the
case of those with farm losses of $25,000 or more and with incomes
of over $50,000 from nonfarm sources. Other provisions of the bill,
primarily relating to farm operations, provide for the recapture of
depreciation upon the sale of livestock, the extension of the holding
period for livestock, and a revision of the treatment in the case of
hobby losses.
(3)
5. Interefit Deductions. — The deduction of interest on funds bor-
rowed to carry investments is generally limited to investment income
plus $25,000.
6. Moving Expenses. — Moving expense deductions are allowed when
changing jobs for househunting trips, for temporary living expenses
prior to locating a new home, and for the expenses of selling an old
home or buying a new one.
7. Limit on Tax Preferences. — In those cases where tax preferences
are not fully subject to tax, provision is made for a minimum tax
on individuals having tax preferences in excess of their taxable in-
come. The additional tax in this case is determined by adding to the
regular income subject to tax, one-half of the tax preferences but only
to the extent they exceed the regular income.
8. Allocation of Deductions. — "V^Hiere taxpayers have substantial tax-
free income, provision is made to allocate itemized personal deductions
between this tax-free income and the individual's taxable income.
9. Income Averaging. — The income averaging provision of present
law is substantially simplified and also made more generally available.
10. Restricted Stock. — In the case of so-called restricted stock plans,
the interest in the j^roperty is taxed at the time of receipt, unless there
is a substantial risk of forfeiture. In the latter event, the value of the
property is taxed when the possibility of forfeiture is removed.
11. Deferred Executive Compensation. — Other deferred executive
compensation is, in general, subject to tax rates as if taxed when
earned, although the tax is not payable until the income is received.
12. Multiple Trusts. — In the case of accumulation trusts (including
multiple trusts), the beneficiary, generally, is to be taxed on the
distributions in substantially the same manner as if he had received
these amounts of income when they were earned by the trust (taking
into account any taxes paid by the trust on the income.)
13. Corporate Mergers. — In the case of corporate mergers, a num-
ber of changes are made. The principal change establishes tests to be
used in determining when amounts cast in the form of "debt" have
sufficient characteristics of "equity"' to be denied the deduction of in-
terest, where this so-called "debt" is used in the acquisition of other
companies. Included among the other provisions is one which limits
the availability of the installment method for reporting gains, where
the debt can be readily traded on the market, and also where the in-
stallment payments are not spread relatively evenly over the period
during which part of the debt is outstanding. Other restrictive changes
are also made in the case of original issue discount aaid premiums paid
on the repurchase by a corporation of its indebtedness which is con-
vertible into its own stock.
14. Multiple Corporationii. — Multiple surtax exemptions in the case
of related corporations are withdrawn over an 8-year period.
15. Stock Dividends. — The rules applicable in determining when
stock dividends become taxable are revised generally to provide for
taxation where one group of stockholders, directly or indirectly, re-
ceives a disproportionate distribution in cash while i\\& interests of
the other shareholders in the corporation are increased.
16. Foreign Tax Credit. — The foreign tax credit is revised in two
respects. First, it is provided that where losses of a corporation op-
erating abroad are offset against domestic income (either of the same
corporation or as the result of filing a consolidated return) , subsequent
earnings from the foreign operations to the extent of one-half of these
earnings remaining after foreign tax, are to be recaptured until the
tax benefit for the domestic operations derived in the case of the initial
offset of the foreign losses is recovered. Secondly, a separate limitation
under the foreign credit is provided in certain cases with respect to
foreign mineral income.
17. Commercial Banks.— Tho, tax advantages of commercial banks,
relating to special reserves for bad debt losses on loans and to capital
gains treatment for bonds held in their banking business are with-
drawn.
18. Mutiial Savings Banks and Savings and Loan Institutions. — The
tax treatment of mutual savings banks and savings and loan associa-
tions is revised to reduce a series of tax advantages presently available
to these financial institutions.
19. Depreciation in Case of Regulated Industries. — Action is taken
generally to limit the depreciation which may be taken in the case
of certain regulated industries, to straight line depreciation unless
the appropriate regulatory agency permits the company in question
to take accelerated depreciation and "normalize" its tax reduction.
However, in the case of existing property, no faster depreciation
may be taken than is presently taken. Companies already on "flow
through'' may not change without permission of their regulatory
agencies.
20. Use of Depreciation in Computing Earning and Profits. — In
computing earnings and profits — which determine whether dividends
are taxable or not — corporations are required to make the computation
on the basis of straight line depreciation. As a result, this tax benefit
cannot be passed onto stockholders.
21. Capital Gains of Corporations. — The alternative capital gains
tax on corporations in increased from 25 to 30 percent.
22. Depletion^ etc. — The percentage depletion rate for gas and oil
wells is reduced from 27i/2 percent to 20 percent. Other depletion rates
are comparably reduced (with five minor exceptions). Percentage
depletion also is eliminated with respect to foreign oil and gas wells.
Additionally, carved out production payments, as well as retained
jjroduction payments (including ABC transactions) are treated as if
they were loans, or the sale of property subject to a mortgage. The
effect of this generally is to prevent such payments from artificially
increasing the percentage depletion deduction and foreign tax credits
or giving rise to income which can offset net operating losses. In
addition, this eliminates the possibility of buying mineral property
with money which is not treated as the taxable income of the buyer.
Finally, recapture rules are applied to certain mining exploration
expenditures to which the rules of present law are inapplicable.
23. Capital Gains. — Capital gain and loss treatment is revised in
several respects. First, the alternative capital gains tax for individuals
was repealed, with the result that in the case of those in the top tax
brackets, the rates may rise to as much as 35 percent (or 321/^ percent
under the new rate structure provided by this bill) ; second, long-term
capital losses of individuals are reduced by 50 percent before being
6
available as an offset against ordinary income ; third, the offset against
ordinary income in the case of husbands and wives filing separate
returns is limited to $500 for each or to the same aggregate amount
as if they filed a joint return ; fourth, the sale of papers by a person
whose efforts created them, or by a person for whom they were
produced, is to give rise to ordinary income; fifth, the holding period
for capital gains is increased from 6 months to 12 months; sixth,
employers' contributions to pension plans when paid out as a part
of a lump-sum distribution, is to be taxed as ordinary income; seventh,
life interests are not to be accorded a covst basis when sold; eighth,
casualty losses and gains are to be consolidated in determining w^hether
they give rise to ordinary loss or tO' gain which is consolidated with
other section 1231 gains or losses; and ninth, transfers of franchises
are not to be treated as giving rise to capital gains if the transferor
retains significant rights.
2i4. Real Estate Depreciation. — Real estate depreciation is revised in
several respects. The 200-percent declining balance (or sum-of-the-
years-digits) method is limited to new housing; other neAv real estate
is limited to 150-percent declining balance depreciation; and all used
property is limited to straight line depreciation. However, 5-year
amortization is allowed for certain rehabilitation expenditures on
low-cost rental housing. Finally, the so-called recapture rules of
present law, in the case of real estate, are revised so that they apply to
depreciation in excess of straight line depreciation. In other words,
upon the sale of property, depreciation in excess of straight line will
be recaptured at that time by converting the capital gain to ordinary
income to the extent of this excess.
25. Oooiyeratives. — The tax treatment of cooperatives is revised to
require patronage dividends and per-unit retams to be revolved out
over a period of no more than 15 years. In addition, the required cash
payout in any year, on either current or prior years' patronage, must
equal at least 50 percent of the amomit of the current year's patronage
(taking into account the 20 percent which under present law must be
paid in cash on the current patronage) .
26. Subchapter S Corporations. — In the case of subchapter S cor-
porations (that is, the corporations treated somewhat like partner-
ships) amounts set aside under qualified i^ension j^lans for shareholder-
employee beneficiaries may not exceed 10 percent of the compensation
paid or $2,500, whichever is smaller.
27. Stute and Municipal Bonds. — State and local governmental units
are given an opportunity to issue taxable obligations and in turn
receive from the Federal Government a payment equal to between
30 and 40 percent of the interest yield of the bond (on issues brought
out after 5 years, the payment will be between 25 and 40 percent).
Additionally, the interest on so-called arbitrage bonds of State and
local governments are denied Federal income-tax exemption.
II. Extension of Surcharge and Excises, Termination of Invest-
ment Credit, and Certain Amortization Provisions (Contained
in H.R. 12290 but Which Have Not Yet Passed the Senate, and
Which Are in H.R. 13270)
1. Surcharge. — The income-tax surcharge at a 5-percent rate is ex-
tended by this bill from January 1, 1970, through June 30, 1970.
2. Excises. — The present excise taxes on communications services
and automobiles are extended for one more year and future reductions
of these taxes are postponed.
3. Investment Credit. — The 7-percent investment credit is repealed.
4. Pollution Control. — Five-year amortization is provided for pollu-
tion control facilities.
5. Railroad Rolling Stock. — Seven-year amortization is provided
for railroad rolling stock, other than locomotives.
III. Adjustments of Tax Burden for Individuals
1. Standard Deduction and Maxinvum Standard Deduction. — ^Over
a 3-year period the standard deduction is increased from 10 percent to
15 percent and the maximum standard deduction is increased from
$1,000 to $2,000. This rate and amount are effective for 1972 and
later years. In 1970 the percentage is 13 percent and the maximum,
$1,400. In 1971 the percentage is 14 percent and the maximum, $1,700.
2. Minimum Standard Deduction and Low-Income Alloivance. —
The minimum standard deduction is increased to a level of $1,100, by
adding to the present minimum what is called a low-income allowance.
This amount is phased out for the income levels above the taxable
levels. This phaseout, however, is used for only 1 year. After 1970 the
full $1,100 allowance will be available for all taxj)ayers whose standard
deduction without regard to the minimum is not in excess of $1,100.
3. To]} Rate on Earned Income. — In the case of earned income, a
maximum rate of tax of 50 percent is provided. This is a maximum
marginal rate, with the result that no earned income will be taxed at
a rate in excess of 50 percent.
4. Tax Treatment of Single Persons. — Single persons, 35 years of age
or more, and persons whose spouse has died, are provided income tax
rates which are halfway between those available to married couples
and those previously available to these single persons. This inter-
mediate tax rate treatment is the category formerly known as head-
8
of -household treatment. In addition, in the case of widows and
widowers with dependent children, age 19 or less or attending school
or college, full income splitting is to be available.
5 Rates.— In 1971 and 1972 tax rate reductions aggregating slightly
over $2.2 billion in each year are provided. The 1972 rates provide
sliffhtlv over a 5-percent reduction for those whose income levels are
above the levels where the low-income allowance and increase m the
standard deduction provide substantially greater reductions.
PART 2
ANALYSIS OF PROVISIONS AND ARGUMENTS FOR AND
AGAINST
As requested by the Committee, the following summary in-
cludes arguments wliich might be raised in support of, or m
opposition to, each provision contained in the House-passed bill.
This listing of the arguments for and against the features of the
House bill is not intended, and indeed it cannot be, all inclusive.
The many different situations which the bill affects make it im-
possible to anticipate every attitude that might be expressed
with respect to the bill. However, it is believed that the principal
positions are reflected in the summary. The order in which the
arguments are presented should not be interpreted as a ranking
of their importance, nor should the phraseology indicate that the
staffs have any position with respect to them.
(9)
PART 2
ANALYSIS OF PROVISIONS AND ARGUMENTS FOR
AND AGAINST
A. Private Foundations
1. Tax on Investment Income
Present law. — Although present law subjects many exempt organiza-
tions to taxation on unrelated business income, investment income is
specifically excepted from this tax.
Problem. — Heavily endowed foundations have substantial income
that is not taxed. Questions have been raised as to why these private
foundations should not pay some of the cost of government since they
are able to pay. Also funds are needed for more and more extensive and
vigorous enforcement of the tax laws relating to foundations. A user
fee is needed to provide funds for this purpose.
House solution. — The bill imposes a tax of 7I/2" percent on a private
foundation's net investment income (interest, dividends, rents and
royalties) and its net capital gains. Deductions are allowed only for
expenses paid or incurred in earning that income and for net capital
losses. Taxes are not imposed upon their receipt of contributions or
grants.
Arguments For. — (1) Since private foundations enjoy the benefits
of Government as do other entities and individuals, they should bear
some portion of the costs of Government, just as do other organizations
and individuals.
(2) The administrative machinery necessary to insure that private
foundations currently distribute their funds for proper charitable pur-
poses is becoming more and more costly. This tax will defray a portion
of that cost. It is a modest levy which will not hamper the operation
of private foundations.
(3) Such a tax should encourage greater reliance upon the public
than upon the one-time beneficence of one individual or family.
(4) Investment income of most other charitable organizations is not
subject to tax (except for income from debt-financed acquisitions and
investment income of social clubs, fraternal beneficiary societies, and
certain employee insurance associations discussed below), and it is
unfair to single out foundations for this special tax.
Arguments Against. — (1) Since the advent of our taxing statutes,
the Government has recognized the special place that private fomida-
tions occupy in our society and has granted them tax-exempt status.
This tax is an incursion into that philosophy and seriously undermines
it.
(2) This tax will fall heavily unon those private foundations who
have a profitable invastment portfolio, and would reduce the fund that
would be available for charitable purposes.
(11)
33-158 O— 69 2
12
(3^ The foundation that secures more current income for current
charitable benefits will be liable for a greater tax than a foundation
which does the minimum that the bill requires, and so the bill discour-
ages good foundation management.
2. Prohibitions on Self-Dealing
Present law. — Under present law, no part of the net earnings of
private foundations and other charitable organizations are permitted
to inure to the benefit of private ^lareholders or individuals. Also,
arm's-length standards are imposed with regard to loans, payments of
compensation, preferential availability of services, substantial pur-
chases or sales, and substantial diversions of income or corpus to (or
from, as the case may be) creators (of trusts) and substantial donors
and their families and controlled corporations. The only sanctions pro-
vided are loss of exemption for a minimum of one taxable year and
loss of charitable contributions deductions under certain circumstances.
Problem. — Arm's-length standards have proved to require dispro-
portionately large enforcement efforts, resulting in sporadic and un-
certain effectiveness of the provisions. Moreover, the subjectivity in-
volved in applying such standards has occasionally resulted in the
courts refusing to uphold sanctions, especially when they are severe in
relation to the offense. In other cases, the sanctions have practically no
deterrent or punitive effect even where there is vigorous enforcement.
Also, many benefits may be derived by those who control a private
foundation even though they deal completely at arm's-length.
House solution. — The bill replaces the arm's-length standards with a
list of specific prohibited self-dealing transactions. A violation of the
provisions results in a tax on the self-dealer of 5 percent of the amount
involved in the violation. If the self-dealing is not corrected within
an appropriate time, then a tax of 200 percent of the amount involved is
imposed upon the self-dealer. Similar taxes at lower rates are imposed
upon the foundation manager who is knowingly involved in the self-
dealing or who refuses to correct the self-dealing but the tax on the
manager may not exceed $10,000. A third level of tax is available, as
described below in Change of Status. The bill also requires that the
foundation's governing instrument must prohibit it from engaging in
the self -dealing transactions described in the Code.
Arguments For. — (1) The provisions of the present Internal Reve-
nue Code which relate to self-dealing in private foundations have
proved to be totally ineffective. Abuses have arisen where individual
taxpayers have benefited by using the tax-exempt private foundation
for their own purposes, rather than for the charitable purpose for
which the foundation was ostensibly founded.
(2) The arms-lengtli tests set forth in the present Internal Revenue
Code are vague, and difficult to enforce. The result is that there is
excessive litigation where, because of the difficulty in tracing the trans-
action involved, the Government is at a tremendous disadvantage.
(3) The fact that, in relation to the particular offense, present sanc-
tions may be inordinately severe causes the courts, as well as the Inter-
nal Revenue Service, to refrain from invoking them even though there
may be self-dealing. Under the bill the sanctions are properly propor-
tioned to the amount involved in the improper transactions and are
imposed upon the self-dealer rather than the foundation.
13
(4) The bill improves on the present law by including in the self-
dealing provisions transactions between private foundations and Gov-
ernment officials.
(5) The highest fiduciary standards require as a practical matter
that self-dealmg be not engaged in, rather than that arm's-length
standards be oteerved. These proposals are intended to impose the
highest standard since experience has shown that lesser standards are
too tempting to many donors and managers.
(6) The requirements as to foundation governing instruments will
facilitate effective State enforcement of State common law and statu-
tory regulation of funds dedicated to charitable purposes.
Arguments Against. — (1) Many innocent transactions will be sub-
ject to sanctions under the bill. Innocent transactions discovered years
later may not be able to be effectively undone, especially where the
foundation and , the donor no longer have the property that was
involved.
(2) The restrictions imposed upon dealings between the foundation
and substantial contributors may well discourage persons from giving
to private foundations if they have widespread business activities.
(3) In many cases, the first-level sanctions will be insufficient to
deter self -dealing transactions which are deliberate and will be exces-
sive in the case of self-dealing transactions that are inadvertent.
(4) The attribution rules are so broad that many private foimda-
tions will not be able to operate effectively because so many of those
whom they would naturally deal with are or may be disqualified per-
sons. In reply to this point it is noted that many of the present diffi-
culties arise precisely because foundations "naturally" deal with their
donors and their donors' businesses.
(5) This provision would prohibit fair and equitable transactions
even where they benefit charity. In addition, it seems unfair to prevent
a donor from clealing with his foundation on the same terms that the
foundation would be willing to deal with an unrelated person.
(6) Rather than have any Federal prohibition on self -dealing,
which is cumbersome and difficult to administer, the jurisdiction of the
]:>roblem is better left to the State courts which have a wider range of
remedies for dealing with the abuses, such as the removal of the fi-
duciaries, the mandatory distribution of income for charitable pur-
poses, surcharge, and reformation.
3. Distributions of Income
Present lata. — A private foundation loses its exemption if its aggre-
gate accumulated income is unreasonable in amount or duration for its
charitable purposes.
Problem, — Under present law, if a private foundation invests in
assets that produce no current income, then it need make no distribu-
tions for charitable purposes, even though the donor has received full
deductions for the value of the nonincome-producing property he
has contributed. Also, current distributions are not required until the
accumulated income becomes "unreasonable". Finally, the sanctions
under present law (as described above under "self -dealing") tend to
be either largely ineffective or else unduly harsh.
House solution. — The bill provides that a private foundation must
distribute all its income currently (but not less than 5 percent of its
14
investment assets), and imposes graduated sanctions in the event of a
failure to make timely distributions. However, provisions are made to
set aside income for later distribution in certiain circumstances and to
carry forward "excess" distributions. Qualifying distributions include
distributions to "public charities" and to private operating founda-
tions, direct expenditures for charitable purposes, and expenditures
for assets to be used for charitable purposes.
Income may be set aside for up to 5 years if approved in advance
by the Internal Revenue Service, if such an arrangement is needed,
as for example, to assure grants for continuing research or as part of
a matching grant program. A tax of 15 percent of the undistributed
amount is imposed where there has been a failure to distribute by the
end of the taxable year after the income w^as received. If the distribu-
tions of the remainders are not made during the "correction period",
then a tax of 100 percent is imposed.
Arguin^nU- For. — (1) These provisions are needed to insure that
charity will begin ]oromptly to receive benefits commensurate wnth the
tax benefits available to donors and their foundations. The 5-year set-
aside and carryover provisions should provide sufficient flexibility.
(2) Tlie 5-percent minimum payout w^ill reduce the incentive to use
foundation assets to control businesses which do not pay substantial
dividends.
(3) This provision would discard the "unreasonable accumulation"
test contained in the present Internal Revenue Code. Under it, a
private foundation can avoid making current distributions for the
benefit of charity by investing in assets that produce no current income
even though the donor may receive substantial tax benefits from his
charitable contribution. Because it is difficult to determine subjectively
when an accumulation has become unreasonable, the present law can-
not be administered.
(4) Frequently under the present law the only available sanction
for an mireasonable accumulation is the loss of exempt status which is
ineffective and unduly harsh in many instances. The bill provides
more appropriate sanctions designed to assure that current earnings
will be distributed to charity.
(5) No privatjB foundation should be permitted to use the tax laws to
carve out a perpetual role in society without having to justify its con-
tinued existence to the contributing general public.
Arguments Against. — (1) The minimum 5-percent payout re-
quirement will force foundations to engage in investment practices that
will not permit them to grow commensurate with the rest of the
economy.
(2) Foundation managers should be the sole judges of the best
timing for the charitable use of foundation income.
(3) A foundation should not be required to distribute earned income
currently if it is invested to produce a fair return. There are legitimate
purposes for keeping a charitable fund intact for a long period of time,
and this provision takes aw\ay fiduciary discretion in a major area of
fiduciary responsibility.
(4) This provision might force an unwise corporate distribution to
satisfy tax requirements and could well discourage many large donors
from leaving substantial bequests to private foundations. Also, the
necessity for an annual determination of the current fair market value
15
of foundation assets will breed litigation in areas where the investment
asset is close-held and is not susceptible of an easy evaluation.
(5) This problem of ac/cumulation is better attacked by allowing
the foundations to control themselves or by placing authority for the
administration of such matters in the State, rather than in the Federal
Government.
4. Stock Ownership Limitation
Present law. — Present law does not deal directly with foundation
ownership of business interests, although some cases have held that
business involvement can become so great as to result in loss of exempt
status.
Problem.- — ^The use of foundations to maintain control of businesses
appears to be increasing. Whether or not the foundation management
is independent of donor control, incentive to control a business enter-
prise frequently detracts from incentive to produce and use funds for
charitable purposes. Temptations are frequently difficult to measure
and sanctions presently are applied only in rare cases.
Hou^se solution. — The bill limits to 20 percent the combined owner-
ship of a corporation's voting stock which may be held by a foundation
and all disqualified persons. If someone else can be shown to have
control of the business, the 20-percent limit is raised to 35 percent.
Existing excess holdings must be disposed of within 10 years (with
interim requirements at 2 years and 5 years) ; excess holdings acquired
by gift or bequest in the future generally must be disposed of within
5 years ; exceptions are provided in the case of i:elated businesses ; and
violations are subject to a series of graduated sanctions.
Arguments For. — (1) Where private foundations own substantial
amounts of stock in corporations, there is a tendency to use the foun-
dation's stockholdings to assert business control and to ignore the pro-
duction of income by the foundation to be used for charitable purposes.
The interests of the foundation's managers are diverted to the main-
tenance and improvement of the business and away from their chari-
table duties.
(2) Even where the ownership of a business by a private founda-
tion does not cause the foundation managers to neglect their charitable
duties, the corporate business may be run in such a way that it unfairly
competes with other businesses whose owners must pay taxes on the
income they realize.
(3) The divestiture requirements are sufficiently gradual (especially
in the case of existing holdings) so as not to unreasonably disrupt the
foundation's investment plans and also the worth of the security being
divested. Even as to the future, 5 years should be sufficient where the
excess holdings develop after knowledge of the new rules.
(4) Requiring divestiture is better than denying deductions because
it permits a donor to give valuable assets to a foundation while allow-
ing the foundation sufficient time to make the assets useful to it.
Arguments Against. — (1) This proposal w411 limit the diversity of
foundations, will seriously inhibit their growth, and will prevent the
creation of new private foundations.
(2) The fact that a donor derives some intangible benefit because
the foundation controls his business does not alter the fact that he has
made an irrevocable commitment to charity and as long as the prop-
16
erty is producing a fair return for charity, there should be no com-
plaint. Any regulation in this area should not be on the foundation's
ownership of other businesses, but should be on the use of funds real-
ized from the operation of the other businesses.
(3) The other provisions of the law and the accompanying sanctions
should correct the abuses resulting from foundation ownership of
other businesses, making this provision unnecessary.
(4) Those whose fortunes consist largely of stock in single enter-
prises will be reluctant to contribute to private foundations since their
only practical method of making a large grant will ultimately require
loss of control over the business enterprise. In some cases, other social
values may be served by protecting a business from the hazard of loss
of control, as where a business has become vital to the economy of a
community.
(5) The appropriate time for disposing of an investment asset
should be left to the discretion of the foundation's managers and not
be directed by the tax laws.
5. Limitations on Use of Assets
Present law. — A private foundation loses its exemption if its ac-
cumulated income is invested in such a manner as to jeopardize the
carrying out of charitable purposes. No similar specific limitations
apply to investment of assets.
Prohlem. — Under present law a private foundation manager may
invest the assets (other than accumulated income) in w^arrants, com-
modity futures, and options, or may jDurchase on margin or otherwise
risk the entire corpus of the foundation without being subject to any
sanctions. (In one case a court held that a consistent practice of such
investments constituted an operation of the foundation for a sub-
stantial non-exempt purpose, but the only sanction was loss of tax
exemption, which did not really improve the status of charity.)
House solution. — The bill imposes upon all the assets of the founda-
tion the same limitations presently applicable only to accumulated
income. As a result, under this provision a foundation could not invest
its corpus in a manner which would jeopardize the carrying out of its
exempt purposes.
Arguments For. — (1) The rationale of the existing limitation
applies to all the assets of a foundation. It is expected that the 100-per-
cent tax on such jeopardizing investments will provide State officials
with the necessary impetus for stronger regulatory supervision over
the investment activities of private foundations.
(2) A tax measured by the amount of the improper investment is a
better way of dealing with the problem than the present law's choice
of either ignoring the impropriety or destroying the foundation's tax-
exempt status.
Arguments Against. — (1) The restrictions placed on fomidation
management by these provisions would hamstring honest and com-
petent trustees in dealing with the foundation's portfolio, and would
limit investment flexibility.
(2) The abuse this provision seeks to prevent is not sufficiently
widespread to require legislative action and in any event, the most
effective way to deal with the problem is through substantive laws of
the State or municipality.
17
(3) The jeopardy investment provision of present law has created
few difficulties largely because it has rarely been enforced; it creates
substantial difficulties of interpretation ; and, these difficulties will be
much magnified by making the present provision applicable to all the
assets of the foundation.
6. Other Limitations
Present Ioao. — Present law requires that no substantial part of the
activities of a private foundation may consist of carrying on propa-
ganda or otherwise attempting to influence legislation. It further pro-
vides that no such organization may "participate in, or intervene in
(including the publishing or distributing of statements) , any political
campaign on behalf of any candidate for public office." The corre-
sponding charitable contributions deduction provision prohibits sub-
stantial propaganda activities but does not deal specifically with the
electioneering activities. Another provision prohibits the use of ac-
cumulated income to a substantial degree for nonexempt purposes.
Problem. — Under the present law's substantial lobbymg provision,
a large organization may safely engage in far more lobbying than a
small organization. Also, many organizations make their views clear
as to which candidates for public office ought to be supported, with
confidence that the drastic remedy of loss of exemption will not be
imposed. Heavily endowed organizations may engage in lobbying or
electioneering and, if exempt status is lost, may continue to avoid tax
on investment income by becoming exempt under other provisions of
the law. The individual grant device is increasingly being used as a
method for funding certain political viewpoints. Organizations that
have been called to task for engaging in such activities have claimed
that they have no responsibility for how their money is used once a
grant has been made.
House solution. — The bill provides that private foundations are to be
forbidden to spend money for lobbying, electioneering (including
voter registration drives), grants to individuals (unless there are
assurances that the grants are made on an objective basis), grants to
other private foundations (unless the granting foundation accepts
certain responsibilities as to the use of the funds by the donee organiza-
tion), and for any other purpose which is not a charitable purpose.
Improper expenditures will be subject to a tax of 100 percent of the
amount paid or incurred. Activities will not be classified as prohibited
"lobbying" if they consist only of making available the results of non-
partisan analysis or research. Also, a private foundation is permitted
to appear before a legislative body with regard to matters that might
affect the existence of the foundation, its powers and duties, its tax-
exempt status, or the deduction of contributions to it.
Voter registration drives will be permitted when conducted on a
nonpartisan basis by broadly supported organizations active in at least
5 States, provided that contributions to the organization are not geo-
graphically limited as to use.
Grants may be made to individuals chosen in open competition or
other nondiscriminatory programmatic basis. Grants may be made in
the form of scholarships or fellowships or for a specific purpose. Grants
to other private foundations (other than operating foundations) are
prohibited unless the granting organization becomes responsible for
18
how the money is spent and for providing information to the Internal
Revenue Service regarding the expenditures.
Arguments For. — (1) The present provision regarding the sub-
stantiality of improper lobbying, as indicated above, has the peculiar
effect of permitting many organizations to engage in significant lobby-
ing activities while others are, for practical purposes, completely for-
bidden to engage in such activities. This bill separates out the per-
missible activities from those which are not permissible and imposes
the same sort of sanction on the large organization as it does on the
small, the same sort of sanction on the heavily endowed organization
as it does on the organization that depends upon current contributions.
(2) The bill corrects a defect in the present law through which
foundations use their money to finance vacations abroad, trips between
jobs for favored beneficiaries, and subsidies for the preparation of ma-
terials furthering specific political viewpoints.
(3) The bill accommodates both the interests of flexibility and re-
sponsibility, recognizing that the funds involved have already received
substantial tax benefits by virtue of their bemg dedicated to charitable
purposes. The foundations granting these funds are the stewards of
public trusts and are no longer in the same posture as individuals who
may dispose of theif own money as they see fit.
Arguments Against. — (1) i?he provisions of the present law are
adequate to take care of those isolated situations where private founda-
tions engage in political activity. To impose further restrictions and
sanctions would unduly restrict them in legitimate foundation activi-
ties.
(2) There is no substantial compelling evidence of abuse in the polit-
ical activity or grant area relating to private foundations and, in any
event, the problem should be met by State — not Federal — regulation.
(3) Private foundations have been increasingly involved in so-called
action or social welfare programs. Prohibition of such activities at
this time is viewed as an attack upon the causes, or as a punishment of
the foundations.
(4) If private foundations are not permitted to "sell" the public as
to their views on major social problems, then government will not be
moved to act on those problems.
7. Disclosure and Publicity Requirements
Present law. — Private foundations must file annual information
, returns describing gross income, expenses, disbursements for exempt
purposes, accumulations, balance sheet, and total amounts of con-
tributions and gifts received. No specific sanctions are provided for
failure- to file a return except for certain criminal provisions appli-
cable in extreme cases. Information required to be furnished on the
information returns is open to the public.
Problem. — Existing law is not sufficient in most cases to provide the
Internal Revenue Service with the information necessary to determine
if the organization continues to be exempt and if it is liable for tax
under the new rules for private foundations and the unrelated income
and other provisions of this bill.
House solution. — The bill requires that information returns be filed
annually by additional exempt organizations, that additional informa-
tion as to donors and highly paid employees be included in the returns.
19
that sanctions of $10 per day be imposed for failure to file on time, and
that certain information regarding violations must be furnished to
appropriate State officials. In addition, the Service must make avail-
able, under regulations, information relevant to any determination
under State law.
A,'yu.niAi.voo tor. — ( 1) While the present law requires certain exempt
organizations to file information returns and unrelated business in-
come tax returns, the experience of the past two decades has indicated
that these returns are inadequate to obtain information that is needed.
This bill would require information on a more current basis, from more
organizations, and would make the information available to more
people, especially State officials, and to Congress for use in determining
the need for further legislation.
(2) By requiring the names and addresses of all substantial con-
tributors, directors, trustees, other management officials and highly
compensated employees, this bill facilitates enforcement of the limita-
tions imposed on self-dealing with "disqualified persons".
(3) The sanction of $10 per day should be more effective than
the present vague possibility of criminal proceedings in the event of
failure to file information returns.
Argutnents Against. — (1) These provisions will compel private
foundations to spend money on bookkeeping and accounting services
that would otherwise be used for charitable purposes. This is especially
undesirable in small foundations which do not have available large
amounts of money and which rely on the ability of a few donors who
may or may not have the ability to keep books and file detailed returns.
(2) The sanctions for failing to file a return are still too severe,
especially since they are imposed on the foundation without any re-
quirement that the Secretary notify the foundation before the sanc-
tion becomes operative.
(3) Privacy is unnecessarily invaded by the requirements of filing
information regarding substantial contributors and payments to
foundation officials. Payments of compensation to such officials are al-
ready sufficiently accounted for by the requirement to file withholding
statements.
8. Change of Status
Present laio. — Under present law, an organization is exempt if it
meets the requirements of the Code, whether or not it has an "exemp-
tion certificate". Violation of the exemption provisions results in loss
of exempt status, either prospectively or back to the time the viola-
tions first occurred.
Problem. — Many organizations do not make their existence known
and thus receive tax benefits, both for themselves and their donors,
without the Internal Revenue Service even being aware of their exist-
ence. In many cases, under existing law, loss of exempt status would
be only a light burden. This is especially true where the foundation
has already received the charitable contributions necessary to endow
it and where it could retain its exemption as to its current income by
qualifying for exemption under another provision of section 501(c).
House solution. — The bill requires new exempt organizations to
notify the Internal Revenue Service if they claim to be exempt under
section 501(c)(3). Existing and new organizations must notify the
20
Service if they claiin to be other than private foundations. Exceptions
may be provided by the Treasury Department to the extent appro-
priate without interfering with proper administration of the law.
If a private foundation seeks to change its status, or if the Internal
Revenue Service determines that it has committed repeated willful
violations (or a willful and flagrant violation) of the limitations
imposed upon private foundations, then the organization must repay
to the Government the aggregate income, estate, and gift tax benefits
(with interest) that have flowed to the foundation and all its sub-
stantial donors since 1913 from the foundation's exempt status. How-
ever, this tax may be abated if the organization distributes all its
assets to public charities or acts as a public charity itself for at least
5 years. The substantial contributors whose tax benefits must be taken
into account are those who have contributed at least $5,000 to the
private foundation in any one year or contributed more than anyone
else to the foundation in any one year, or, in the case of a trust, have
created the trust.
Arguments For. — (1) The Government ought to know what orga-
nizations receive tax benefits.
(2) A charity should not be permitted to deliberately cause loss of its
exempt status in order to relieve itself of the law's limitations upon its
activities, after it has already obtained substantial tax benefits.
(3) Required repayment of tax benefits (with interest) should make
it highly unlikely that any organization which receives the benefits of
such exempt status would take lightly its obligations to serve charitable
purposes.
(4) The bill should greatly strengthen the position of State officials
that seek to regulate the activities of private foundations, and, where
necessary, conserve their assets and structures by causing the courts to
replace the trustees or foundation managers who threaten to bring
such a tax liability upon the foundation.
(5) The provision is needed to close a loophole through which
existing private foundations already endowed with tax deductible con-
tributions could change their character, secure tax-exempt status under
another provision of the law, and yet escape the restrictive rules
applied by the bill to private foundations.
(6) The bill properly requires organizations seeking to avoid the
private foundation rules to clearly establish that they are not private
foundations.
Arguments Against. — (1) It is harsh and unrealistic to require a
foundation to repay tax benefits realized by contributors with respect
to amounts they contributed to the foundation; determination of
the amount of the tax benefit is an impossible task to impose on the
foundation.
(2) It is impractical to require that all new exempt organizations
must notify the Internal Revenue Service that they are claiming sec-
tion 501(c) (3) exempt status. Such a requirement cannot be enforced
with respect to such exempt organizations as Boy Scout troops, local
Parent-Teacher Associations, and similar organizations.
(3) Views as to what constitutes proper forms of charity change
wit^h time. Those who have been entrusted with the task of directing a
21
foundation's activities should be given the flexibility to determine
where the best advantages lie in the Internal Revenue Code as to
carrying out of their entrusted functions.
(4) The sanction presented by the bill is so great that it would be
unlikely that any court would be willing to enforce it.
9. Changes in Definitions
Present laio. — "Private foundation", a telrm not found in present
law, is often used to describe an organization, contributions to which
may be deducted only up to 20 percent of an individual donor's ad-
justed gross income. Deductions of up to 30 percent of a donor's income
may be taken for contributions to (1) churches, (2) schools, (3) hos-
pitals, (4) fund-raisers for schools, (5) States and subdivisions, and
(6) publicly supported charities.
Problem,. — In general, the problems that gave rise to the statutory
provisions of the bill discussed above appear to be especially prevalent
in the case of organizations presently in the 20-percent group. How-
ever, it appears that certain organizations presently in the 20-percent
category generally do not give rise' to the problems which have led
to the restrictions and limitations described above.
House solution. — Tlie bill provides that a "private foundation" is
any organization described in section 501 (c) (3) other than :
(1) organizations, contributions to which may be deducted
to the extent of 30 percent of an individual's income ;
(2) certain types of broadly publicly supported organizations
(including membership organizations) ;
(3) organizations which are organized and operated exclu-
sively for the benefit of one or more organizations described in
(1) or (2), and are controlled by one or more organizations, or
operated in connection with one organization described in (1)
or (2) ; and
(4) organizations which are organized and operated exclusively
for testing for public safety.
The first and fourth categories are essentially the same as in pres-
ent law. The second category includes a variety of organizations which
receive substantial public support and whose income from endow-
ments generally is quite limited. Among those to which this provision
would apply are symphony societies, alumni associations, and the
Boy Scouts of America. The remaining category includes religious
organizations (other than churches), university presses, and certain
organizations created and controlled by, and for, "(c)(3) organiza-
tions" which are not private foundations.
Arguments For. — (1) The objective definition of the term "private
foundation" insures that the purposes of the bill can be carried out.
(2) Tlie fact that organizations described above are not classified
as "private foundations" does not to any significant extent present
problems, since in general these organizations must justify their con-
tinued existence to the public and they usually spend for charitable
purposes at least as much as their income (in many cases as much as
their investment income plus contributions combined).
Arguments Against. — (1) Any arithmetic test necessarily means
that two organizations, virtually identical in all respects, can receive
22
sharply different tax treatment because one just barely meets the test
and escapes the private^ foundation rules, while the other just misses the
test and falls subject to all of them. The bill would be quite arbitrary
in its application.
(2) Limitations ought to be imposed upon all exempt organizations
or upon none. To do otherwise, from this viewpoint, results in a dis-
crimination which must not be allowed in the tax laws.
10. Private Operating Foundation Definition
Present laio. — "Operating fomidation", a tenn not found in pres-
ent law, is sometimes used to describe the type of organization, con-
tributions to which qualify for the unlimited charitable contribution
deduction under present law but nevertheless do not qualify under the
30-percent deduction provision. (See Tax Treatment of Charitable
Contributions, below.) In order to qualify for such treatment under
present law, substantially more than half the organization's assets and
substantially all its income must be used or expended directly for its
exempt purposes or functions.
Problem. — Certain types of organizations which are included in the
category of private foundations largely depend for their source of
funds upon contributions from other private foundations. Although
such organizations perform useful work, nevertheless, many of the
problems giving rise to the limitations described above appear to be
present in the case of these organizations.
House solution. — The bill provides that an "operating foundation,"
eligible to receive qualifying distributions from other private founda-
tions (but otherwise subject to the limitations imposed upon private
foundations) is an organization substantially all of the income of which
is expended directly for the active conduct of its exempt purposes or
functions, provided that either (1) substantially more than half its
assets are devoted to such activities or to functionally related busi-
nesses or (2) substantially all its support (other than from endow-
ments) is normally received from at least 5 independent exempt orga-
nizations and from the general public (but no more than 25 percent of
its support may be received from any one such exempt organization).
These two categories of organizations relate generally to (1) mu-
seums and similar organizations and (2) special-purpose foundations,
such as learned societies, associations of libraries, and organizations
which have developed an expertise in certain substantive areas and
which receive grants of funds and direct their research in those speci-
fied substantive areas.
Argu7nents For. — ( 1 ) Operating foundations make a significant con-
tribution to the framework of American culture. The bill recognizes
an operating foundation is carrying out its charitable purpose and pro-
perly permits private non-operating foundations to pay over their
own income to it.
(2) The provision j^ermitting private foundations to make grants
to such institutions may be important to the preservation of major
sources of learning.
Arguments Against. — (1) The bill is discriminatory because while it
23
allows a grant to be made to an operating foundation which is sup-
ported by at least five independent private foundations, it would not
allow a grant to a foundation which received its support from one (or
less than five) private foundations. An organization in the latter cate-
gory which is engaged in worthy, and beneficial programs should also
be treated as an operating foundation.
(2) Museums, etc., may range from the world-famous Smithsonian
Institution to organizations which are little more than the whim of a
wealthy person. Blanket exemptions for such organizations would
point to a route for easy avoidance by private foundations generally.
(3) Operating foundations should not be subject to any of the lini-
itations imposed upon private foimdations generally. (In rebuttal, it
is noted that this might pro\dde too great an incentive for private
foundations to avoid the limitations by creating operating founda-
tions which they control.) It is contended by others that operating
foundations ought to be subject to the same rules as private
foundations.
11. Hospitals
Present law. — Hospitals qualify for exempt status and may receive
deductible charitable contributions as "charitable" organizations.
Problem. — It has been contended by some agents that hospitals (un-
like educational organizations, churches, and others) must provide
some significant amount of charitable services on a no cost-or-loss basis
in order to be exempt as "charitable" organizations.
House solution. — The bill provides that hospitals are to have the
same status as churches and educational institutions for purposes of tax
exemption, charitable contributions, and a variety of other matters.
The other requirements for exemption — no inurement of profits to pri-
vate individuals, operation and organization exclusively for exempt
purposes, no substantial legislative activities, and no political elec-
tioneering activities — continue to apply to hospitals.
Argumsnts For. — (1) These provisions are necessary to eliminate
challenges to the tax-exempt status of hospitals on the ground that the
hospitals are accepting insufficient numbers of patients at no charge
or at rates that are substantially below cost.
(2) By establishing hospitals as a separate exempt category and
removing the indefinite test of to what extent a hospital must serve-
those who cannot pay, this bill removes the uncertainty surrounding
the hospital's continued ability to draw necessary support from the
public or from private foundations to accomplish its fimction .
(3) Hospitals perform a useful function of the sort that deserves
treatment in section 501 (c) (3) on the same basis as the other organiza-
tions specifically named in that provision.
(4) The present environment of governmental assistance to permit
medical care to be made available to those otherwise unable to pay,
appears to make obsolete the need for hospitals themselves to subsidize
the providing of medical care to poor people. This is as true regarding
hospitals as it is regarding schools and churches.
24
Arguments Against. — (1) In order to be tax exempt, hospitals his-
torically have been required to render service to the poor whether or
not there was an ability to pay for the services rendered. These pro-
visions w^ould do away with that requirement and many marginal in-
come families that are now ineligible for payment of hospital care
under Medicaid, and who do not have sufficient resources to pay for
hospital treatment might be denied care now available to them. This
is especially true in States that do not pay for hospital care of
people who are eligible for general assistance under the welfare pro-
grams of the State. The bill will pose particular hardships on ])oor
families priced out of hospital care by continually rising health costs
and this w ill put greater pressure on Congress to expand the Medicaid
program at the very time Congress is seeking to contract and moderate
it.
(2) To the extent hospitals contend Medicare and Medicaid does not
pay their full costs they would also contend that they are providing
charitahl-e services for those patients. If the bill were not changed
these hospitals could refuse Medicare or Medicaid patients with im-
punity or could limit their services to such patients unless the Gov-
ernment met the hospitals' unilateral cost demands. Without the
balancing effect of the present Internal Revenue Service position,
government might be faced with the choice of either complying with
such payment ultimatums or seeing millions of poor and aged citizens
denied necessary care in community nonprofit hospitals.
(3) There is no substantial evidence that contributors to hospitals
will decrease or stop their donations because the Internal Revenue
Service is questioning the tax-exempt status of a hospital (or hospi-
tals) on the ground that sufficient charitable services are not being
rendered to the poor.
(4) The extent of free and "below cost" hospital care has dimin-
ished greatly with the advent of public programs such as Medicare
and Medicaid. The pressure to provide free care has lessened to the
extent that these multi-billion dollar programs and private hospital
insurance are now paying for many of those whose bills previously
went unpaid.
(5) The bill discards the charitable basis — ^the "community service
to all" concept — on which tax exemption of hospitals is founded.
(6) If there is a legitimate complaint that Internal Revenue rul-
ings are too vague on this point, a clarifying amendment establishing
statutory standards is the appropriate remedy rather than the blanket
approach of the House provision.
(7) Since the need for new legislative language has arisen because
of uncertainties in administration, then the resolution of such uncer-
tainties could be handled on an administrative basis.
12. Effective Dates
The provisions described above apply to taxable years beginning
after December 31, 1969, except that additional time is permitted in
the case of existing organizations to reform their governing instru-
ments to conform to the new law as to business holdings and distribu-
tions of income. Also the 5-percent minimum distribution requirement
will not apply, in the case of existing organizations, until taxable
years beginning after December 31, 1971. However, any organization
25
that was a private foundation (under the rules of this bill) for its
last taxable year ending before May 27, 1969, will be subject to the
bill's requirements until it terminates its status as described pre-
viously in Change of Status.
B. OTHER TAX-EXEMPT ORGANIZATIONS
1. The "Clay Brown" Provision or Debt-Financed Property
Present law. — Under present law, charities and some of the other
types of exempt organizations are subject to tax on rental income from
real property to the extent the property was acquired with borrowed
money. However, this provision does not apply to all tax-exempt
organizations and there is an important exception which includes
rental income from a lease of 5 years or less. Nor does the tax apply to
income from the leasing by a tax-exempt organization of assets consti-
tuting a going business.
Prohlem. — During the past several years weaknesses in the present
provision relating to debt-financed property have been exploited in
several different respects. As a result a large number of tax-exempt
organizations have used their tax-exempt privileges io buy businesses
and investments on credit, frequently at what is more than the nmrket
price, while contributing little or nothing themselves to the transac-
tion other than their tax exemption.
In a typical Clay Broion situation a corporate business is sold to a
charitable or educational foundation, which makes a small or no down
payment and agrees to pay the balance of the purchase price out of
]:)rofits from the property. The charitable or educational foundation
liquidates the corporation, leases the business assets back to the seller,
who forms a new corporation to operate the business. The newly formed
corporation pays a large portion of its business profits as "rent" to
the foundation, which then pays most of these receipts back to the
original owner as installment payments on the initial purchase price.
In this manner in the Clay Brown case (1965 Supreme Court case),
a business was able to realize increased after-tax income, and the
exempt organization acquired the ow^nership of a business valued at
$1.3 million without the investment of its own funds. In the recent
(1969) University Hill Foundation case, the Tax Court upheld the
acquisition of 24 businesses by the University Hill Foundation in the
period 1945 to 1954. Other variants of the debt-financed property
problem have also been used.
House solution. — The House bill amends the code to provide that
all exempt organizations' income from "debt-financed" property is to
be subject to tax in the proportion the property is financed by debt.
Thus, for example, if a business or investment property is acquired
subject to an 80 percent mortgage, 80 percent of the income and 80
percent of the deductions are taken into account for tax purposes. As
the mortgage is paid off, the percentage taken into account diminishes.
Capital gain on the sale of debt-financed property is also taxed. The
amendment makes exceptions for property to be used for an exempt
purpose within a reasonable time, and also for property acquired by
gift or inheritance under certain conditions. Also there is a special
exception for the sale of annuities, and for debts insured by the
26
Federal Housing Administration to finance low and moderate income
housing. For years before 1972, only indebtedness incurred on or after
June 28, 1966, will be taken into account.
Arguments For. — (1) This provision would cure the defect in the
present law which allows an exempt organization to acquire a going
business for an inflated price, without the investment of its own funds,
and pay the owners from the untaxed earnings of the business.
(2) The bill creates fair competition between tax-free and taxpaying
organizations seeking to purchase a going business.
(3) The bill discourages an owner of a going business from seek-
ing to sell it to a tax-free organization in an arrangement by which
he in effect, converts his ordinary income from the operation of that
business into a tax-favored capital gain.
(4) Tax-exempt organizations should be taxed on their debt-
financed income because in such cases they are, in effect, using their
tax-exempt status to "earn" income for them. It is suggested that the
exemption was intended simply to remove from tax income on con-
tributions from ih& general public, not as a tool for generating income
without ]>ublic contribution. In this regard, both the United States
Catholic Conference and the National Council of Churches have ex-
pressed approval both of the objectives and the approach of the House
bill.
Arguments Against. — (1) Other provisions of the bill extend the
unrelated business income tax to organizations which previously were
tax-exempt on income from a going business. Thus, they can no longer
purchase a business with tax-free earnings, and this provision of the
bill is now unnecessary.
(2) Rather than devise special rules for business purchased by tax-
exempt organizations, the general rules of the bill governing debt-
financed acquisitions could be applied.
(3) Tlie House provisions go too far in that they apply to debt-
financed cases whether or not the property is leased back to the sellers.
(4) Tliis is an infringement on the tax-exempt status generally
^available for charitable organizations with respect to investment
income
2. Extension of Unrelated Business Income Tax to All Exempt
Organizations
Present law. — Under present law the tax on unrelated business in-
come applies only to certain tax-exempt organizations. These include :
(a) Charitable, educational, and religious organizations (other than
churches or conventions of churches) ;
(b) Labor and agricultural organizations ;
(c) Chambers of commerce, business leagues, real estate boards, and
similar organizations;
(d) Mutual organizations which insure deposits in building and
loan associations and mutual savings banks ; and
(e) Employees' profit sharing trusts and trusts formed to pay (non-
discriminatory) supplemental unemployment compensation.
Problem. — In recent years, many of the exempt organizations not
now subject to the imrelated business income tax — such as churches,
social clubs, fraternal beneficiary societies, etc.- — have begun to engage
27
in substantial commercial activity. Some churches, for example, are
engaged in operating publishing houses, hotels, factories, radio and TV
stations, parking lots, newspapers, bakeries, restaurants, etc. Further-
more, it is difficult to justify taxing a university or hospital which runs
a public restaurant or hotel or other business and not tax a country
club or lodge engaged in similar activity.
House solution. — The House bill extends the unrelated business in-
come tax to all exempt organizations (except United States instrumen-
talities created and made tax exempt by a specific act of Congress).
The organizations which will newly be made subject to this tax include
churches and conventions or associations of churches, social welfare
organizations, social clubs, fraternal beneficiary societies, employees'
beneficiary organizations, teachers retirement fund associations, benev-
olent life insurance associations, cemetery companies, credit unions,
mutual insurance companies, and farmers cooperatives formed to
finance crop operations.
As under present law, in general this tax does not api^ly unless the
business is "regularly carried on" and therefore does not apply, for
example, in cases where income is derived from an annual athletic ex-
hibition. (See discussion under Investment Income, below.) Under the
amendments made by the bill, in the case of any membership organiza-
tion, any income resulting from charges to the members for goods, fa-
cilities, and services supplied in carrying out the exempt function is
not subject to tax.
The bill contains several administrative provisions including one
providing that no audit of a church is to be made unless the principal
internal revenue officer for the region believes that the church may be
engaged in a taxable activity. Churches will not be subject to tax for
six years on businesses they now own.
Alignments For. — (1) The bill eliminates unfair competition of tax-
free organizations engaged in the same business as taxpaying
organizations.
(2) The bill corrects an injustice by which some tax-exempt organi-
zations are subjected to tax on their l3usiness income wliile o'tliers re-
main tax-free with respect to the same sort of business income.
(3) Unless the unrelated business income of all exempt organiza-
tions is taxed, the Federal revenues will suffer as more and more busi-
ness moves from taxable to tax-exempt entities.
(4) Both the United States Catholic Conference and the National
Council of Churches have indicated approval of the taxation of the
unrelated businass income of churches.
(5) The bill raises questions as to what activities will be related or
unrelated in imposing this tax, whether intermittent activities such
as football games held to raise funds for charitable purposes and ac-
tivities primarily carried on for the benefit of members of the or-
ganizations are subject to tax. For the most part, these problems should
be resolved on the basis of the present rulings and regulations al-
though, because of the new types of organizations being brought under
the tax, the regulations probably will require expansion to cover new
types of situations.
Arguments Against. — (1) The provisions tax unrelated business in-
come, even though there is no competition with a taxpaying entity.
313-158 O— 69 3
28
(2) In taxing the investment income of organizations not heretofore
subject to the unrelated income tax, such as a social club, little addi-
tional revenue would be provided but many of these clubs would be
destroyed.
3. Taxation of Investment Income of Social, Fraternal, and
Similar Organizations
Present Za^t'.— Under present law the investment income of social
clubs, fraternal beneficiary societies, and employees' beneficiary asso-
ciations are exempt from income tax.
ProhJem. — Since the tax exemption for social clubs, fraternal bene-
ficiary societies, and employees' beneficiary associations is designed, at
least in part, to allow individuals to join together to provide recrea-
tional or social facilities without tax consequences, the tax exemption
operates properly only where the sources of income of the organiza-
tion are limited to receipts from the membership. Wliere an organiza-
tion receives income from sources outside the membership, such as in-
come from investments, upon which no tax is paid, the membership
receives a benefit from the tax-exempt funds used to provide pleasure
or recreational facilities.
House solution. — The House bill provides for the taxation (at regu-
lar corporate rates) of the investment income and other unrelated in-
come of social clubs, fraternal beneficiary associations, and employees'
beneficiary associations. This will not apply, however, to such income
of fraternal beneficiary associations and employees' beneficiary asso-
ciations to the extent it is set aside to be used only for the exempt in-
surance function of these organizations and for charitable purposes.
If in any year an amount is taken out of the set- aside and used for
any other purpose, the amount taken out will be subject to tax in
such year.
Arguments For. — (1) This provision is needed to close the loophole
where certain exempt organizations which are comprised of individuals
who join together for mutual benefit (such as a social club) receive
untaxed income from investments and funnel the benefit to their mem-
bers in the form of an increase in services or a reduction in the cost of
services or membership fees.
(2) Continuing tax-exempt status for investment income in these
situations distorts the original purpose of Congress in enacting the
present law and it should be corrected.
Arguments Against. — (1) It is harsh and discriminatory to tax as
unrelated busines income the investment income of these specific or-
ganizations while similar income received by other exempt organiza-
tions is not taxed.
(2) It is incorrect to assume that the benefit of the investment income
in these organizations inures to the personal benefit of the members.
In many cases the income is used for charitable or for other socially
desirable purposes, and these efforts should not be thwarted.
(3) Congress traditionally has exempted from tax for so-called
tax-exempt organizations any investment income received. To tax the
investment income of these organizations represents an infringement
of that traditional exemption.
29
4. Interest, Rent, and Royalties From Controlled Corporations
Present law. — ^Under present law, rent, interest, and royalty expenses
are deductible in computing the income of a lousiness. On the other
hand, receipt of such income by tax-exempt organizations generally
is not subject to tax.
ProhleiTh. — Some exempt organizations "rent" their physical plant to
a wholly owned taxable corporation for 80 percent or 90 percent of all
the net profits (before taxes and before the rent deduction) . This ar-
rangement enables the taxable corporation to escape nearly all of its
income taxes because of the large "rent" deduction. While courts have
occasionally disallowed some, or all, of the rent deduction, the issue is
a difficult one for the Internal Revenue Service.
House solufian. — The code would be amended to provide that in any
case in which an exempt organization owns more than 80 percent of a
taxable subsidiary, interest, annuities, royalties and rents are to be
treated as "unrelated business income" and subject to tax. The deduc-
tions connected v.'ith production of such income are allowed.
Arguments For. — (1) This provision eliminates the "gimmick"
whereby a subsidiary corporation is set up by an exempt organization
to operate a business which earns income and pays interest, rents and
royalties to the exempt organization in amounts sufficient to wipe out
any tax liability of the subsidiary corporation.
(2) Since the interest, rents and royalties are derived from the op-
eration of an active business it would be wrong to allow the exempt
organization to treat it as passive income, thwarting the intent of the
Congress in enacting the unrelated business income tax.
Arguments AgainM. — (1) The bill is too broad and would tax as un-
related income all interest, rents, and royalties received by a tax-
exempt organization from a controlled corporation without regard to
the purpose or propriety of such payments.
(2) The bill would tax monies that would otherwise be used for
charitable purposes.
(3) To tax rental, interest, or royalty income in such cases could
result in a tax on investment income even though the payments to the
tax-exempt organization were small relative to the value of the fa-
cilities or other property rented, borrowed, or subject to a. royalty
payment.
5. Limitation on Deductions of Nonexempt Membership Orga-
nizations
Present law. — Some courts have held that taxable membership or-
ganizations cannot create a "loss" by supplying their members services
at less than cost. Other courts have held instead that such a "loss" is
permissible, that the expenses of providing such services at less than
cost will offset from taxation additional income earned by the or-
ganization from investments or other activities.
Prohhnt. — In some cases membership organizations, which also
have business or investment income, serv^e their members at less than
cost and offset this book loss against their business or investment in-
come and as a result pay no income tax. In an important decision the
courts held that a non-exempt water company was not subject to tax
30
when the "losses" in supplying its members water offset its investment
income. Otlier courts have held to the contrary.
House solution. — The House bill provides that in the case of a tax-
able membership organization the deduction for expenses incurred in
supplying sei-vices, facilities or goods to members is allowed only to
the extent of the income from such members. Thus, no membersihip or-
ganization will be pennitted to escape tax on business or investment
income by using this income to serve its members at less than cost and
deducting the book "loss."
Arguments For. — (1) To permit a membership organization to
offset investment or business income against a loss arising from
services provided to members is the same as if an individual were al-
lowed to offset his personal or recreational expenses against his in-
vestment income.
(2) This provision is necessary to prevent exempt membership
organizations from attempting to avoid the effect of the unrelated
business income rule by giving up their exempt status and deducting
the cost of providing services for members from its investment or
nonmembership income.
Argument Against. — (1) There is nothing reprehensible about a
non-exempt membership organization offsettmg the expense of pro-
viding services to members against investment income or income de-
rived from services to nonmembers. The Courts have upheld this
approach.
(2) To deny an offset of membership losses and investment income
is to tax a membership organization on income when it has no profit.
6. Income From Advertising
Present law. — Late in 1967 the Treasury promulgated regulations
under which the income from advertising was treated as "unrelated
business income" even though such advertising appeared, for example,
in a periodical related to the educational or other exempt purpose of
the organization.
Problem. — Wliile the House concluded that the regulations reached
an appropriate result in specifying that in carrying on an advertising
business in competition with other taxpaying advertising businesses,
a tax should be paid, nevertheless, the statutory language on which
the regulations were based was sufficiently miclear so that substantial
litigation could have resulted from these regula/tions. To overcome
this problem the regulations were placed in the tax law.
House solution. — The House bill provides that income from ad-
vertising (or a similar activity) is included in unrelated business in-
come even though the advertising is carried on in connection with ac-
tivities related to the exempt purpose.
Arguments For. — (1) Advertising in a journal published by an
exempt organization competes with tax-paying organizations that sell
advertising, and this bill properly taxes the advertising income of the
exempt organization.
(2) Activity such as advertising should not lose its identity as a
trade or business because it is carried on within a larger scope of
similar activities which may be related to the exempt purpose of the
organization.
31
Arguments Against. — (1) Advertising in trade journals does not
normally compete to any great extent with tax-paying corporations,
publishing commercial magazines because it is usually of a technical
nature, and attracts the attention only of those people interested in the
professional asi^ects of the publication.
(2) This bill ignores the fact that it is difficult to separate tech-
nical comment (such as where technical benefits of a pharmaceutical
product is described in an advertisement in a medical journal) from
pure advertising.
(3) Many trade organizations depend on advertising income heavily,
and the taxing of that income will seriously hamper their exempt en-
deavors.
C. CHARITABLE CONTRIBUTIONS
1. 50 Percent Charitable Limitation Deduction
Present law. — Under present law, the charitable contributions de-
ductions allowed individuals generally is limited to 30 percent of a
taxpayer's adjusted gross income. In the case of gifts to certain private
foundations, however, the deduction is limited to 20 percent of a tax-
payer's adjusted gross income. (In addition, in limited circumstances,
a taxpayer is allow^ed an unlimited charitable contributions deduc-
tion. )
Problem. — It has been suggested that it would be desirable to
strengthen the incentive for charitable giving by increasing the f)res-
ent 30 percent limitation on the charitable contribution to 50 percent
of a taxpayer's income. Moreover, it was hoped that this increase would
offset any decreased incentive resulting from the repeal of the un-
limited charitable contributions deduction (see page 32). In addition,
the combination of these two actions means that charity (on a tax-
free basis) can remain an equal partner with respect to an individual's
income but cannot reduce an individual's tax base by more than one-
half.
House solution. — The House bill increases the general 30 percent
limitation on an individual's charitable contribution deduction to 50
percent. The 20 percent charitable contribution deduction limitation
in the case of gifts to private foundations is not increased by the bill.
Also, contributions of appreciated property would continue to be
subject to the present 30 percent limitation. These changes apply to
taxable years beginning after 1969.
Arguments For. — (1) It is more appropriate to have a general
limitation of 50 percent with no unlimited charitable contribution
deduction so that all taxpayers may be treated equally with respect
to charitable giving.
(2) Limiting the additional contribution deduction to cases where
no appreciation is involved will prevent any further increase in ad-
vantages arising from the omission of income given to charity from
an individual's tax base.
Arguments Against. — (1) This provision benefits a particular class
of taxpayers who already are able to take advantage of tax privileges
that are net aviiilable to lower income taxpayers.
(2) The justification for increasing the limit was to provide a
greater incentive to offiset the disincentive resulting from a series of
32
restrictive charitable contribution suggestions which were rejected by
the House. Since the bill does not contain these restrictions this "com-
pensation" is unwarranted.
(3) From the standpoint of the educational institutions and public
charities the increase to 50 percent in terms of total contributions they
receive will not result in the very large contributions they could solicit
under the unlimited charitable contribution deduction.
(4) Failing to make the additional contribution deduction available
in the case of property which has appreciated in value will minimize
the value of this additional deduction.
2. Repeal of the Unlimited Deduction
Present law. — The charitable contributions deduction for individu-
als generally is limited to 30 percent of the taxpayer's adjusted gross
income. An exception to the 30 percent general limitation allows a
taxpayer an unlimited charitable contributions deduction, if in 8 out
of the 10 preceding taxable years the total of the taxpayer's charitable
contributions plus income taxes paid exceeded 90 percent of his tax-
able income.
Problem,. — It has been pointed out that the unlimited charitable
contributions deduction has permitted a number of high-income per-
sons to pay little or no tax on their income. It appears that the charita-
ble contributions deduction is one of the two most important itemized
deductions used by high-income persons, who pay little or no income
tax, to reduce their tax liability.
HoxLSc sohifion. — The unlimited charitable contributions deduction
is to be eliminated for years beginning after 1974. During the interim
period, an increasing limitation is to be placed on the amount by which
the deduction can reduce the individual's taxable income. For taxable
years beginning in 1970, the unlimited deduction is not to be allowed to
reduce a person's taxable income in this manner to less than 20 per-
cent of his adjusted gross income. This percentage is to be increased by
6 percentage points a year for the years 1971 through 1974. The bill
also provides that +he percentaere of the taxpayer's income which must
be given to charity or paid in income taxes each year in order to
qualify for the unlimited deduction during this interim period is to
l)e reduced to 80 percent in 1970. and is then to be reduced by 6 percent-
age points a year for the years 1971 through 1974.
Argum^Mts For. — (1) It is not equitable to allow certain high-
income persons to pay little or no income tax by means of the unlimited
charitable contributions deduction, while most tax])ayers are presently
limited to a maximum charitable deduction of 30 percent of income
each year (with a 5-year carryover of contributions in excess of 30
percent). Further, the qualification requirement for an unlimited
deduction is related not to total economic income but only to "taxable"
income, and some taxpayers have sufficient tax-free income and/or
other deductions so that they may qualify and yet not actually have
given up most of their economic income.
(21) Charitable contributions should not be allowed to reduce an
individual's tax base by more than one-half. Thus, the repeal of the
unlimited charitable deduction, combined with an increase in the gen-
eral limitation from 30 percent of adjusted gross income to 50 percent
33
means that charity can remain an equal partner (but no more) with
respect to an individual's income.
(3) This provision closes a "loophole" that has allowed a small
number of high-income persons to pay little or no tax on their incomes
which sometimes exceed $1 million a year,
(4) Because of the possibility of contributing highly appreciated
property to charity for which the unlimited charitable contribution
deduction is claimed, a high income taxpayer can contribute an amount
sufficient to offset his income and place himself in a more favorable
after-tax situation than if he had not made the charitable contribution ;
thus, the tax shelter is of greater benefit to the donor than the con-
tribution is to charity. It is this tax-planning which motivates the
gift — and not a desire to benefit charity.
Arguments Against. — (1) The relatively small gain in tax revenue
($25 million a year) would result in a large direct loss to philanthropic
endeavors.
(2) The bill fails to recognize that persons who make a significant
long-run commitment of a very large part, of their income make a
contribution to charitable activities that would be difficult to replace.
3. Charitable Contributions of Appreciated Property
Present law. — A taxpayer who contributes property which has ap-
preciated in value to charity generally is allowed a charitable con-
tributions deduction for the fair market value of the property at the
time of contribution. Further, no income tax is imposed on the ap-
preciation in value of the property at the time of the gift. In addition,
if property is sold to a charity at a price below its fair market value —
a so-called bargain sale — the proceeds of the sale are considered to be
a return of the cost and are not required to be allocated between the
cost basis of the "sale" part of the transaction and the "gift" part of
the transaction. The seller is allowed a charitable contributions deduc-
tion for the difference between the fair market value of the property
and the selling price (often at his cost or other basis) .
Problem. — The combined effect of not taxing the appreciation in
value and at the same time allowing a charitable contributions deduc-
tion for the fair market value of the property given is to produce
tax benefits significantly greater than those available with respect to
cash contributions. The tax saving which results from not taxing the
appreciation in the case of gifts of long-term capital assets is the cap-
ital gains tax which would have been paid if the asset were sold. In
the case of ordinary income tyi^e assets, however, this tax saving is at
the taxpayer's top marginal tax rate. In either case, the tax saving
from not taxing the ap]3reciation in value is combined with the tax
saving of the charitable deduction at the taxpayer's top marginal rate.
As a result, in some cases it is possible for a taxpayer to realize a
greater after-tax profit by making a gift of appreciated property than
by selling the property, paying the tax on the gain, and keeping the
proceeds.
In addition, in the case of a so-called bargain sale to a charity (often
at the taxpayer's cost or other basis), the taxpayer is allowed a char-
itable deduction for the appreciation in excess of the sales price and no
34
tax is paid on this appreciation. In cases where the sales price is equal
to the cost basis, the entire appreciation is deductible and escapes
taxation.
House solution. — The bill in the case of certain charitable contri-
butions of appreciated property takes this appreciation into account
for tax purposes. This is true of gifts to a private foundation, other
than a private operating foundation or one which within 1 year dis-
tributes an equivalent amount to, or for the use of, "public" charitable
organizations or private operating foundaitons. Also, under the bill,
appreciation in value is taken into account in the case of gifts of tan-
gible personal property (such as paintings, art objects, and books), a
future interest in property, and property which would give rise to
ordinary income if sold. Where the appreciation is taken into account,
the taxpayer has the option of reducing his deduction to the amount
of his cost or other basis for the property, or taking a charitable de-
duction for the fair market value of the property but at the same
time including the appreciation in value of the property in his income.
These provisions relate to gifts of appreciated property made after
1969.
In the case of so-called bargain sales to charities — where a taxpayer
sells property to a charitable organization for less than its fair market
value (often at its cost basis) — the bill provides that the cost or other
basis of the property is to be allocated between the portion of the prop-
erty "sold" and the portion of the property "given" to the charity on
the basis of the fair market value of each portion. This provision
applies to sales made after May 26, 1969.
Arguments For. — (1) The charitable contributions deduction was
not intended to provide greater — or even nearly as great — tax benefits
in the case of gifts of property than would be realized if the property
were sold. In gifts of appreciated property where the tax saving is so
large, little, if any, charitable motivation may remain. In such cases, the
Federal Government is almost the sole contributor to the charity.
(2) Concerning the specific types of appreciated property where the
House bill requires appreciation to be taken into account for tax
purposes, it is maintained that these types of property either result
in the maximum tax benefit where the taxpayer is likely to be better
off by making the contribution than by retaining the property (i.e.,
ordinary income property) or are very difficult to value and often re-
sult in overvalued claims for deductions (i.e., tangible personal prop-
erty and future interests in property) .
(3) With regard to gifts of appreciated property to i^rivate non-
operating foundations, it is thought that there is a high possibility
that the property itself (or its equivalent value) will not actually be
used for charitable purposes until some distant time in the future. This
latter limitation may have the effect of increasing gifts of appreciated
property to "public" charities, since those who are primarily interested
in the tax benefits presumably would make their gifts of appreciated
property to such charities.
(4) This provision partially closes the loophole whereby high-
bracket taxpayers are able to realize a greater after-tax profit by
making a gift of appreciated property to charity than they are by
selling it, paying the tax on the gain, and keeping the proceeds.
35
(5) Because the donor received the beneficial enjoyment of giving his
property to charity, it is appropriate to tax the appreciation in value
of the property to him.
(7) The present system of allowing a contribution deduction for the
fair market value of property without requiring that the appreciation
be included in the donor's income has led to many abuses of the char-
itable contribution deduction involving gifts of paintings, statuary
and similar art objects at artificially inflated prices calculated to pro-
duce the maximum tax benefit for the donor. The bill corrects this
practice.
Arguments Against. — (1) This type of giving represents a major
source of income to private educational institutions and colleges, and
if it were eliminated Federal funds would be needed to support these
colleges, raising constitutional questions regarding the use of Federal
funds because of the traditional separation of Church and State.
(2) The result is much too complex and discriminatory in that gifts
of the same type of property may receive different tax treatment, de-
pending on the type of recipient,
(3) It does not appear to be appropriate to differentiate between
types of property given to the same charitable organization — proper-
ties which may have identical fair market values in the hands of the
taxpayer.
(4) Requiring the appreciation in value to be included in the tax
base if the fair market value is claimed as a deduction for certain
charitable gifts is a significant departure from the accepted practice of
not taxing mirealized appreciation as "income."
4. Two- Year Charitable Trust
Present Iolw. — Under present law, an individual may establish a
trust for two years or more with the income from property placed in
the trust being payable to charity. In such a case although the trust
instrument provides that after the designated period of time the prop-
erty is to be returned to him, the income from the trust property is
not taxed to the individual. However, the individual does not receive
a charitable contributions deduction in such a case.
Prohlern. — The special two-year charitable trust rule has the effect
of permitting charitable contributions deductions in excess of the gen-
erally applicable percentage limitations on such deductions. For ex-
ample with the 50 percent limitation on such deductions contained in
the House bill, the maximum deductible contribution that could gen-
erally be made each year by an individual who had $100,000 of dividend
income (but no other income) would be $50,000. However, if the in-
dividual transfered 60 percent of his stock to a trust with directions to
pay the annual income ($60,000) to charity for two years and then
return the property to him, the taxpayer would exclude the $60,000
from his own income each year. In effect, then, the individual has
received a charitable contributions deduction equal to 60 percent of
his income.
House solution, — The House bill eliminates the rule under which an
individual is not taxed on the income from property which he trans-
fers to a trust to pay the income to charity for a period of at least two
years. This provision applies to transfers after April 22, 1969.
36
Argument Fo7\—{l) This provision would prevent the avoidance of
the limitations on the charitable contribution deduction through the
device of a two-year charitable trust. In effect, the two-year trust rule
is nothing more than a subterfuge for assigning income.
Arguments Against.— (1) There is little abuse connected with the
two-year charitable trust rule and in many cases it leads to an ultmiate
gift of the total corpus to a charitable institution.
(2) The import of this provision is contrary to the objective of
encouraging philanthropy highlighted by the provision which raises
the ceiling on the charitable contribution deduction to 50 percent.
5. Charitable Contributions by Estates and Trusts
Present laio. — Present law allows a nonexempt trust (or estate) a
full deduction for any amount of gross income which it permanently
sets aside for charitable puriwses. There is no limitation on the amount
of this deduction.
Problem.. — To retain the deduction allowed by present law for non-
exempt trusts for amounts set aside for charity (rather than paid to
charity) was viewed as inconsistent with other changes made by the
House bill in the treatment of charitable trust-s.
Nonexempt trusts generally are subject to the same requirements and
restrictions imposed on the private foundations since to the extent of
the charitable interest their use achieves the same result. The cuiTent
income distribution requirement generally applicable to foundations is
not imposed on these nonexempt trusts, however, but the same result
is achieved by denying the set-aside deduction to these trusts for their
current income. In other words, to obtain the charitable deduction the
nonexempt trusts must pay out their income currently for charity
much in the same manner as private foundations are required to do.
In the case of a charitable remainder trust (i.e., a trust which pro-
vides that the income is to be paid to a noncharitable beneficiary for
a period of time and the remainder interest is to go to charity) the
House bill provides that if specified requirements are met, the trust
is to be tax exempt. These requirements are designed to limit the
allowance of a charitable deduction for the remainder interest upon
creation of the trust to situations where there is a reasonable correlation
between the amount of the deduction and the benefits that the charity
will ultimately receive. Where these requirements are met, and the
trust is thus accorded tax-exempt status, there is no need to allow
the trust a deduction for amounts set aside for charity. To accord non-
exempt trusts (with a remainder interest for charity) consistent treat-
ment, it is necessary to deny them a deduction for amounts set aside
for charity.
House solution. — The bill eliminates the set-aside deduction pres-
ently allowed nonexempt trusts. What were nonexempt trusts which
meet the annuity or unitrust rules with respect to their remainder
charitable interests are with respect to this interest treated as exempt
trusts. This provision applies to amounts set aside after the enact-
ment of the bill.
Argument For. — Allowing nonexempt trusts a deduction for
amounts set aside for the future use of charity is not consistent with
the other limitations placed by the bill on charitable trusts.
37
Argument Against.— The elimination of this deduction will dis-
courage trusts from setting aside amounts for charity,
6. Gifts of the Use of Property
Present Imv. — Under existing law a taxpayer may claim a charitable
deduction for the fair-rental value of property which he owns and
gives to a charity to use for a specified time. In addition, he may
exclude from his income the income which he would have received and
been required to include in his tax base had the property been rented
to other parties.
Prohlem. — By giving a charity the right to use property which he
owns for a given period of time a taxpayer achieves a double benefit.
For example, if an individual owns an office building, he may donate
the use of 10 percent of its rental space to a charity for one year. He
then reports for tax purposes only 90 percent of the income which he
would otherwise have been required to report if the building were
fully rented, and he claims a charitable deduction (equal to 10 per-
cent of the rental value of the building) which offsets his already
reduced rental income.
House solution. — ^The House bill provides that the charitable deduc-
tion is not to be allowed for contributions to charities of less than
a taxpayer's entire interest in property. Therefore, no deduction will
be allowed w^here a contribution is made of the right to use property
for a period of time. In such a case, however, a taxpayer will be able
to continue to exclude from his income the value of the right to use
property so contributed. This provision applies with respect to gifts
made after April 22, 1969. ^
Arguiiwnt For. — It is appropriate to eliminate the double bene-
fit which taxpayers have enjoyed with respect to contributions of the
use of their property. This provides gi"eater equity for taxpayers gen-
erally, in that many taxpayers do not have property which can be
utilized in this manner.
Arguments Against. — (1) When an individual donates the use of
])roperty to a charitable organization he does not receive a double bene-
fit because while, under the present law, he receives a deduction for
the full rental value of the property he is not actually receiving any
income from third parties while the property is being used by the
charitable organization.
(2) The contribution of the use of property is a valuable gift, giving
a charity exclusive control and possession for a period of time, and
should be treated in the same manner as an outright gift of property.
7. Charitable Remainder Trusts
Present law. — Under present law an individual may make an in-
direct charitable contribution by transferring property to a trust
and providing that the trust income is to be paid to private persons
for a period of time with the remainder to go to a charity. Generally, a
charitable contributions deduction is allowed for the remainder in-
terest given to charity. The amount of the deduction is based on the
present value of the remainder interest which is determined by using
actuarial life expectancy tables and an assumed interest rate of 3^^
per cent.
Prohlem. — Present rules allow a taxpayer to receive a charitable
contribution deduction for a gift to charity of a remainder interest in
38
trust which is substantially in excess of the amount the charity may
ultimately receive. This is because the assumptions used in calculating
the value of the remainder interest may bear little relation to the actual
investment policies of the trust. For example, the trust assets may be
invested in high-income, high-risk assets. This enhances the value of
the income interest but decreases the value of the charity's remainder
interest. This factor, however, is not taken into account in computing
the amount of the charitable contribution deduction.
House solution. — The bill limits the availability of a charitable con-
tribution deduction in the case of a charitable gift of a remainder in-
terest in trust to situations where there is a closer correlation between
the amount to be received by charity and the amount of the deduc-
tion allowed on the creation of the trust. In general, a deduction is to
be allowed only where the trust specifies the annual amount which is to
be paid to the noncharitable income beneficiary either in dollar terms
or as a fixed percentage of the value of the trust's assets ( as determined
each year) .
The amount of the deduction allowed on the creation of the charita-
ble remainder interest in trust, thus, would be computed on the basis
of the actual relative interests of the noncharitable income and the
charitable remainder beneficiaries in the trust property.
Generally, this provision applies to transfers in trust made after
April 22, 1969 (except in the case of the estate tax where it applies
Avith respect to persons dying after the enactment of the bill).
Argv/inents For. — (1) The limitations provided by this provision
on the allowance of a charitable contribution deduction for gifts
of remainder interests in trust will assure a better correlation be-
tween the deduction allowed and the benefit to charity. This is because
the limitation will remove the present incentive to favor the non-
charitable income beneficiary over the charitable remainder beneficiary
by means of manipulating the trust's investments,
(2) The bill properly prevents the taking of a charitable contribu-
tion deduction for ostensible gifts of charitable remainder interests in
trust where it is not probable that the gift will ultimately be received
by the charity (such as where the charitable interest is only a con-
tingent remainder interest) or where the trust permits invasion of the
charitable share for the benefit of the non-charitable interest.
Arguments Against. — (1) This provision is not necessary because
local laws which impose heavy responsibilities upon trustees and
fiduciaries serve as sufficient assurance that trusts will be handled
properly.
(2) The limitations restrict the flexibility presently available to
persons who wish to make gifts to charity in the form of a remainder
interest in trust. This smaller degree of flexibility might lead to an
undue curtailment of this type of charitable gift.
8. Charitable Income Trust With Noncharitable Remainders
Present Ixno. — Under present law, a taxi)ayer who transfers prop-
erty to a trust to pay the income to a charity for a period of years
with the remainder to go to a noncharitable beneficiary, such as a
friend or member of his family, is allowed a charitable contributions
deduction for the value of the income interest given to charity. In
addition, neither he nor the trust is taxed on the income earned by the
trust which is given to charity.
39
Problem. — A taxpayer receives a double tax benefit where he is al-
lowed a charitable deduction for the value of an income interest in
trust given to charity and also is not taxed on the income earned by the
trust.
House solution. — The bill generally provides that a charitable con-
tribution deduction is not to be allowed where a person gives an in-
come interest to charity in trust unless he is taxable on the trust in-
come. Moreover, even in this case, the charitable deduction will not
be allowed unless the charity's income interest is in the form of a
guaranteed annuity or is a fixed percentage (payable amiually) of
the value of the trust property (as determined each year).
The bill also, in effect, provides for the recapture of the part of the
charitable deduction previously received by a taxpayer where he
ceases to be taxable on the trust income (i.e., that part of the deduction
representing the income on which the taxpayer will not be taxed is
recaptured).
The provision applies to transfers of property to trusts after April
22, 1969.
Arguments For. — (1) The bill is needed to prevent a taxpayer from
taking a charitable contribution deduction for the present value of
an income interest in trust, and at the same time failing to pay a tax
on the income earned by the trust.
(2) It assures in cases where a deduction is allowed that the amount
received by charity will bear a reasonable correlation to the amount of
the deduction.
Argu/ments Against. — (1) This provision is not necessary because
local laws which impose heavy responsibilities upon trustees and
fiduciaries serve as sufficient assurance that the trusts will be handled
properly.
(2) Since this provision restricts the charitable contribution deduc-
tion in certain cases, it is undesirable because it will therefore decrease
contributions to charity.
D. FARM LOSSES
1. Gains From Dispositions of Property Used in Farming Where
Farm Losses Offset Nonfarm Income
Present l-aw. — Under present law, income losses from farming may
be computed under more liberal accounting rules than those generally
applicable to other types of businesses. A cash method of accoimting
under which costs are deducted currently may be used, rather than
an accrual method of accounting and inventories mider which the
deduction of costs would be postponed. In addition, a taxpayer in the
business of farming may deduct expenditures for developing business
assets (such as raising a breeding herd or developing a fruit orchard)
which other taxpayers would have to capitalize. In addition, capital
gains treatment quite often is available on the sale of farm asset-s.
Problem. — Although the si:>ecial farm accounting rules were adopted
to relieve farmei"s of bookkeeping burdens, these rules have been used
by some high-income taxpayers who are not primarily engaged in
farming to obtain a tax, but not an economic, loss which is then de-
ducted from their high-bracket, nonfarm income. In addition, when
these high-income taxpayers sell their farm investment, they often
40
receive capital gains treatment on the sale. The combination of the
current deduction against ordinary income for farm expenses of a
capital nature and the capital gains treatment available on the sale
of farm assets produces significant tax advantages and tax savings for
these high-income taxpayers.
House solution. — The bill generally provides that a gain on the sale
of fann property is to be treated as ordinary income to the extent of
the taxpayer's previous farm losses. For this purpose, a taxpayer must
maintain an excess deductions account to record his fann losses. In the
case of individuals, farm losses must be added to the excess deductions
account only if the taxpayer has more than $50,000 of nonfarm income
for the year and, in addition, only to the extent the farm loss for the
year exceeds $^5,000. The amount in a taxpayer's excess deductions
account would be reduced by the amount of farm income in a subse-
quent year.
The amount of farm losses recaptured on a sale of fann land would
be limited to the deductions for the taxable year and the four previous
years with respect to the land for soil and water conservation expendi-
tures and land clearing expenditures.
To the extent gain on the sale of farm property is treated under
these rules as ordinary income, this would reduce the amount in the
taxpayer's excess deductions account.
The recapture rales provided by the bill would not apply if the tax-
payer elected to follow generally applicable business accoimting rules
(i.e., used inventories and capitalized capital expenses).
This provision applies to dispositions of fann property in years be-
ginning after 1969.
Arguments For. — This provision will limit the tax advantages cur-
rently available in the case of farming operations by recapturing upon
the sale of farm property the farm losses which the taxpayer had
deducted from ordinary income. In addition, the provision would not
affect the small bona fide farmer because of the high dollar limitations.
(2) The present farm tax accounting rules should not be allowed to
continue because they have resulted in a tax abuse. By the use of these
provisions, some high-income taxpayers have carried on limited farm-
ing activities ( including racehorse breeding) as a sideline to obtain a
tax loss which is deducted from their high-bracket nonfarm income.
(3) These losses are not economic losses but arise instead from the
deducation of capital costs which, under the tax laws applicable
to most other industries, would reduce capital gains instead of offset-
ting ordinary income.
(4) The tax abuse in this area has become so large that in recent
years a growing body of investment firms have advertised that they
would arrange a farm loss for persons in high tax brackets. The adver-
tising emphasizes the fact that "after tax" dollars may be saved by the
use of "tax losses" from fanning operations. Thus, these provisions
have created an industry which manufactures farm "tax losses" as
their stock in trade.
(5) The Treasury Department has submitted statistics for 1964,
1965, and 1966 which clearly demonstrates that the average "farm
loss" on an individual basis increases as the taxpayer's adjusted gross
income increases.
41
Arguments Against. — (1) The proposed change would complicate
bookkeeping and accounting records which are kept by farmers.
Farmers forced to comply with the new provision would have their
operational costs increased because of the outside professional help
which they would have to retain.
(2) It would also discourage the flow of risk capital to rural areas.
Generally, in line with this argument is the statement that objectives
(improved livestock strains, crop experimentation, etc.) of the U.S.
Department of Agriculture are being accomplished less expensively
than the Government could do it itself.
(3) The limitations provided by this provision are too high, with
the result that the pix)vision will have little, if any, application in the
case of many persons using the farm loss provisions as tax shelters.
(4) This provision would have relatively little effect on the hobby
loss farmer, since this type of farmer generally would realize fewer
gains on farm property that would bring the recapture rules into
operation.
2. Depreciation Recapture
Present law. — Present law provides that when a taxpayer sells
personal property used in a business, there is a recapture of the de-
preciation claimed on the property. In other words, the gain on the
sale of the property is treated as ordinary income, leather than capital
gain, to the extent of the depreciation previously claimed. These rules
do not apply, however, to livestock.
Problem. — The effect of the exclusion of livestock from the depreci-
ation recapture rule is to allow a taxpayer to convert ordinary income
into capital gain with substantial tax savings. This occurs because the
depreciation is deducted currently from ordinary income taxed at the
regular rates, but the gain on the sale of the livestock is taxed only at
the lower capital gains rates.
House solution. — The bill eliminates the exception for livestock from
the depreciation recapture rules. Thus, gain on the sale of livestock will
be treated as ordinary income, rather than as capital gain, to the extent
of the previous depreciation deductions.
This provision applies to years after 1969, but only to the extent of
the depreciation taken after 1969.
Arguments For. — (1) This provision is favored because it elimi-
nates the present disparity of treatment, as far as depreciation recap-
ture is concerned, between livestock and other types of property used in
a business.
(2) Taxpayers should not be able to use the present depreciation
deduction rules for livestock to convert income taxed at ordinary rates
into income taxed at capital gains rates.
Arguments Against. — ( 1 ) Present tax laws should not be made more
stringent against the farm industry at a time when it is undergoing
severe economic problems.
(2) An extension of the complicated depreciation recapture rules
to the farm industry runs counter to the established position of the
Federal government since 1916 to provide simple tax rules for farmers.
42
3. Holding Period for Livestock
Present law. — Present law allows gain on the sale of livestock held
for draft, breeding, or dairy purposes to be treated as a capital gain,
if the animal has been held by the taxpayer for one year or more.
Problem. — A one-year holding period allows taxpayers to make
short-term, tax-motivated investments in livestock. For example, a
taxpayer can go into the livestock business to build up a breeding herd
over a short period of time, currently deduct the expenses of raising the
animals against his other income which is taxed in the high bracket,
and then sell the entire herd at the lower capital gains rates.
House solution. — The bill extends the required holding period for
livestock. Livestock will not qualify under the bill for capital gains
treatment, unless the animal has been held by the taxpayer for at least
one year after it normally would have been used for draft, breeding, or
dairy purposes. The present one-year rule, in effect, still applies where
an animal is purchased after it has reached the qualifying age.
The bill also extends this holding period requirement to livestock
held for sporting purposes, such as horse racing.
This provision applies to livestock acquired after 1969.
Arguments For. — (1) The holding period for livestock, in order to
qualify for the capital gain rate, should be increased because the pres-
ent period is not long enough to resolve the question of whether the
taxpayer is truly holding the animal for draft, breeding, or dairy
purposes or whether he is holding it for sale in the ordinary course of
business. The intentions of the taxpayer w^ould be more clear if the
taxpayer is required to hold the animal for at least one year after the
animal has reached the age when it would nonnally have first been
used for draft, breeding or dairy purposes.
(2) The bill correctly reserves capital gain classification until the
taxpayer has clearly begun to hold such animals as capital assets.
(3) Tliis provision is favored on the grounds that by extending the
required holding period for livestock, it will lessen the attractiveness
of short-term, tax-motivated investments in livestock.
Arguments Against. — (1) Present tax niles should not be made
more stringent against the farm industry at a time when it is under-
going severe economic problems.
(2) Under present law the holding period for farm animals is one
year, or twice the amount of the holding period required for other
types of capital assets (six months). Although other provisions of the
bill would increase the general holding i^eriod for capital assets to
one year, this provision would discriminate against many raised farm
animals by increasing the holding period for them, in some cases, to
periods in excess of three years (three times the general period).
(3) Questions are raised as to whether the holding period provided
by the bill is, in fact, sufficiently long to significantly decrease the
present tax advantages of livestock operations (i.e., whether it is
appreciably longer than the period for which a tax-motivated investor
otherwise would hold livestock) .
4. Hobby Losses
Present law. — Present law contains a so-called hobby loss provision
which limits to $50,000 per year the amount of losses from a "business"
carried on by an individual that he can use to offset his other income.
43
This limitation only applies, however, if the losses from the business
exceed $50,000 a year for at least five consecutive years. Moreover, cer-
tain specially treated deductions are disregarded in computing the
size of the loss for this purpose.
Problem. — This hobby loss provision generally has been of limited
application because it usually is possible to break the required string
of five loss years. In addition, where the provision has applied to dis-
allow the deduction of a loss, the taxpayer has been faced in one year
with a combined additional tax attributable to a five-year period.
House solution. — The bill replaces the present hobby loss pix)vision
with a rule which disallows the deduction of losses from an activity
carried on by the taxpayer where the activity is not carried on with a
reasonable expectation of profit. An activity would be presumed to
liave been carried on without this expectation of profit where the losses
from the activity were greater than $25,000 in three out of five vears.
This provision applies to years beginning after 1969.
Arguments For. — (1) This provision will provide a more effective
and reasonable basis than does present law for distinguishing between
situations involving a business activity carried on for profit and situ-
ations where taxpayers are merely attempting to utilize losses from an
operation to offset other income.
(2t) The hobby loss provision presently in the tax law has been of
very limited application because taxpayers have been abl^to rearrange
their income and deductions to avoid the 5-year requirement of the
present law.
(3) Some court decisions have adopted procedural rules in the farm-
ing cases which have made it difficult to show that the loss which the
taxpayer has incurred was the result of a "hobby" rather than the
result of legitimate business activity.
Alignments Against. — (1) The bill fails to recognize that farming
generally is a risky operation and that substantial losses are frequently
incurred in early years.
(2) The discouragement of risk capital in this industry would im-
pair animal husbandry, and the development of new and better crop
strains and farming techniques.
(3) By restricting the application of the presumption that an
activity is not carried on for profit to cases where the loss from the
activity exceeds $25,000, the effectiveness of the provision in dealing
with hobby loss situations may be miduly limited.
(4) This provision will result in farmers who experience losses
(e.g., because of crop failures) being harassed by revenue agents seek-
ing to apply this provision.
E. LIMITATION ON DEDUCTION OF INTEREST
Present law. — Present law allows individual taxpayers an itemized
deduction, without limitation, for all interest paid or accrued during
the taxable year.
Problem. — ^The present deduction for interest allows taxpayers to
voluntarily incur a substantial interest expense on funds borrowed to
purchase growth stocks (or other investments initially producing low
income) and to then use the interest deduction to sihelter other income
from taxation. Where a taxpayer's investment produces little or no
33-158 0—69 4
44
current income, the effect of allowing a current deduction for interest
on funds used to make the investment-is to allow the interest deduction
to offset other ordinary income while the income finally obtained from
the investments results in capital gains.
The principal reason why the 154 high- income nontaxable tax re-
turns for 1966 paid no tax was the deduction allowed for "other inter-
est" (that is, interest other than that on a home mortgage and other
than interest incurred in connection with a business) . In many of these
cases, the interest deduction was substantially greater than the invest-
ment income and, thus, was used to shelter other income from taxation.
House solution. — The bill limits the deduction allowed individuals
for interest on funds borrowed for investment purposes. The limitation
does not apply to interest incurred in a trade or business. Under the
limitation, a taxpayer's deduction for investment interest would be
limited to the amount of his net investment income (dividends, inter-
est, rents, etc.), plus the amount of his long-term capital gains, plus
$25,000.
Investment interest in excess of $25,000 would first offset net invest-
ment income and then would offset long-term capital gain income
(long-term gain offset in this manner would not be taken into account
in computing the 50 percent capital gains deduction) .
In the case of partnerships, these limitations apply at both the
partnership and the partner levels.
A carryover for disallowed interest would be allowed under which
the disallowed interest could be used to offset investment income (and
capital gains) in subsequent years. The basic limitation, however,
would be applicalble in the subsequent years.
This provision applies to vears beginning after 1969.
Argiimenfs For, — (1) This provision would limit the use of the in-
terest deduction in connection with funds borrowed for investment pur-
ix)se as a means of offsetting noninvestment income, such as a salary. In
other words, a taxpayer could not voluntarily incur a substantial
interest expense in connection with what is initially a low income
producing investment which eventually may result in capital gains and
at the same time use the interest deduction to reduce his other taxable
income.
(2) Interest on investment borroAving is a controllable expense as
it is usually not necessary for a taxpayer to borrow substantial amounts
for investment purposes and to incur the interest expense in connection
with that borrowing. Accordingly, it is appropriate to place a limita-
tion on the deduction for investment interest, matching the limitation
on the deduction for controllable charitable contributions.
(3) A taxpayer who incurs current interest expense, substantially
in excess of his current investment income, is interested not only in ob-
taining the resulting mismatching of income and the expense of earn-
ing that income but also in deducting the expense from ordinary in-
come while realizing the income as a tax-favored capital gain.
(4) Examination of the tax returns, descril^ed bv former Secretary
of the Treasury, Joseph W. Barr, as reporting no income tax liability
for many wealthy individuals for 1966, revealed that interest deduc-
tions were a principal contributing factor to their tax avoidance.
45
Arguments Against. — (1) The provision interferes with the long-
standing principle behind the cash receipts and disbursements method
of accounting that expenses are deducted when they are paid and in-
come is taxed when it is received.
(2) Additional tax deductible record-keeping costs will be incurred
to comply with this change.
(3) This limitation could adversely affect the stock or real estate
markets where borrowed funds presently play an appreciable role.
Additionally there are difficulties in distinguishing between invest-
ment interest and business interest which this provision may not
adequately deal with. An example of this is the case where the tax-
payer purchases 100 j)ercent of the stock of a corporation. Although
the limitation would appear to apply to this situation, it is questionable
whether the purchase of the stock is made for investment purposes
rather than for business purj)oses.
(4) This provision is unnecessarily harsh on legitimate investment
transactions where good investment considerations, rather than tax
considerations, are motivating factors.
F. MOVING EXPENSES
Present laio. — A deduction from gross income is allowed for certain
moving expenses related to job-relocation or moving to a first job. The
deductible exj^enses are those of transporting the taxpayer, members
of his household and their belongings from the old residence to the
new residence, including meals and lodging en route.
Two conditions must be satisfied for a deduction to be available.
First, the taxpayer's new principal place of work must be located at
least 20 miles farther from his former residence than his former prin-
cipal place of work (or, if the taxpayer had no fonner place of work,
then at least 20 miles from his former residence) . Second, the taxpayer
must be employed full time during at least 39 weeks of the 52 weeks
immediately following his arrival at the new principal place of work.
Generally, the courts have held that reimbursements for moving
expenses other than those which may be deducted are includible in
gross income.
Prohlem. — Job-related moves often entail considerable expense in
addition to the direct costs of moving the taxj)ayer, his family, and
personal effects to the new job location. These additional expenses in-
clude certain costs of selling and purchasing residences, househunt-
ing trips to the new^ job location, and temporary living expenses at
the new location while permanent housing is obtained.
Moreover, the 20-mile test allows a taxpayer a moving expense
deduction even where the move may merely be from one suburb of a
locality to another, and the 39-week test denies the deduction where a
taxpayer is prevented from satisfying the test by circumstances
beyond his control.
House sohition. — The bill extends the present moving expense deduc-
tion to also cover three additional types of job-related moving expenses :
46
(1) travel, meals, and lodging expenses for pre-move househunting
trips; (2) expenses for meals and lodging in the general location of
the new job location for a period of up to 30 days after obtaining
employment; and (3) various reasonable expenses incident to the sale
of a residence or the settlement of a lease at the old job location, or to
the purchase of a residence or the acquisition of a lease at the new job
location. A limitation of $2,500 is placed on the deduction allowed iFor
these three additional categories of moving expenses. In addition,
expenses for the househunting trips and temporary living expenses
may not account for more than $1,000 of the $2,500.
The bill also increases the 20-mile test to a 50-mile test, and pro-
vides that the 39-week test is to be waived if the taxpayer is unable
to satisfy it due to circumstances beyond his control. Finally, the bill
requires that reimbursements for moving expenses must be included
in gross income. These provisions generally apply to years beginning
after 1969.
Arguments For. — (1) 'It is appropriate to give more adequate rec-
ognition in the tax law to additional moving expenses which are
incurred in connection with job-related moves. Moving expenses to a
new job location may be viewed as a cost of earning income. From this,
it may be argued that expenses reasonably incident to a job-related
move should be deductible as are direct moving expenses under present
law.
(2) The present law unreasonably discriminates in favor of "old"
employees who are reimbursed for their moving expenses, on the one
hand, as contrasted to "old" employees who are not reimbursed and
"new" employes, whether or not they are reimbursed, on the other.
This is so because individuals in the former category are not required
to report their reimbursements and include them in income for tax
purposes. (Of course, they get no deduction for their expenses.)
(3) Mobility of labor is highly desirable and the more complete
deduction provisions for moving expenses in the bill fosters such
mobility.
Arguments Against. — (1) The general philosophy of the income
tax law is to deny a tax deduction for personal, family and living
Expenses, and for capital expenditures. The bill violates this general
rule, enlarges the present moving expense deduction and makes it
more of a precedent for allowance of still other personal family
or living expenses.
(2) Mobility of labor, though desirable, is not motivated by a tax
deduction. If a job offer in another location is attractive on its own,
or if job opportunities are scare in the employee's present location,
he will make a necessary move without a tax reward.
(3) Existing rules for "old" employees who are reimbursed bv their
employers for a move required by the employer — the only situation
where tax relief is warranted — are adequate to prevent hardship where
the move is beyond the employees' control.
(4) The allowance of a deduction for the additional moving ex-
penses is primarily advantageous to the professional or managerial
employee, who is most likely to move, as well as to incur substantially
higher moving costs due to his more expensive mode of living.
47
(5) The dollar limitations on the additional moving expense deduc-
tion are unrealistically low.
G. LIMIT ON TAX PREFERENCES
Present ^ law. — Under present law, there is no limit on how large a
part of his income an individual may exclude from tax as a result
of the receipt of various kinds of tax exempt income or special deduc-
tions. Individuals w^hose income is secured mainly from tax-exempt
State and local bond interest, for example, may exclude practically
all their income from tax. Similarly, individuals may pay tax on
only a fraction of their economic income, if they enjoy the benefits of
accelerated depreciation on real estate. Individuals may also escape
tax on a large part of their economic income if they can take advantage
of the present special farm accounting rules or can deduct charitable
contributions which include appreciation in value which has not been
subject to tax.
Problem. — The present treatment, ^^hich imposes no limit on the
portion of his income that an individual may exclude from tax, results
in an unfair distribution of the tax burden. This treatment results
in large variations in the tax burdens placed on individuals who re-
ceive different kinds of income. In general, high-income taxpayers,
who get the bulk of their income from personal services, are taxed at
high rates. On the other hand, those who get the bulk of their income
from such sources as tax-exempt interest and capital gains or who
can benefit from accelerated depreciation on real estate pay relatively
low rates of tax. In fact, individuals with high incomes who can
benefit from these provisions may pay lower average rates of tax
than many individuals with modest incomes. In extreme cases, indi-
viduals may enjoy large economic incomes without paying any tax
at all.
House solution. — The House bill provides a limit on tax preferences
under which no more than 50 percent of the taxpayer's total income
(adjusted gross income plus tax preference items) can be excluded
from tax. The tax preference items to which this provision applies
are: (1) tax-exempt interest on both new and old issues of State and
local bonds (to be gradually taken into account over a 10-year period
at a rate of one-tenth of the interest per year) ; (2) the excluded one-
half of capital gains; (3) the untaxed appreciation in value of prop-
erty for which a charitable contributions deduction is allowed; (4)
the excess of depreciation claimed on real property over straight line
depreciation; and (5) fanii losses to the extent they result from the
use of special farm accounting rules.
The limit on tax preferences applies only to taxpayers with at least
$10,000 of tax preference items for the year. A 5-year carryover is
provided for disallowed preferences. This provision applies to years
beginning after 1969.
Arguments For. — (1) The limit on tax preference is based on the
premise that individuals generally should be required to pay tax on
at least one-half of their economic income.
(2) The limit on tax preferences has the advantage of making sure
that individuals generally pay tax on a substantial part of their
48
income. It, therefore, serves as a second line of defense against the
avoidance of income taxes, to back up the first line of defense against
such avoidance offered by the remedial provisions in the House bill
which limit the scope of specific tax preferences.
(3) The bill corrects the unfair discrimination in present law which
favors those taxpayers who derive their income from the ownership of
property as contrasted Avith those who earn their living from wages
and salaries.
(4) The present law improperly encourages investment of capi-
tal in certain areas for tax consideration rather than good business
reasons and violates the principle that taxes should have a neutral
impact on economic decisions.
(5) Many individuals with large incomes benefit from tax pref-
erences to the extent that they pay lower average rates of effective
tax than many individuals with moderate incomes. This makes a
mockery of a tax system based on the ability to pay.
Arguments Against. — ( 1 ) This limitation is an imperfect substitute
for direct action on the preferential income tax provisions which
cause today's tax injustice. Each particular item of tax preference
should be considered on its own merits and should be adjusted
accordingly.
(2) Enactment of a limit on tax preference complicates present law
by imposing a new income tax system on top of our present system
thereby compounding the complexity of the tax laws and adding con-
siderable administrative difficulties to the existing system.
(3) This new approach could become the forerunner of a gross
receipts tax on all taxpayers.
(4) The bill raises a constitutional question as to the power of
Congress to tax income from State and local government obligations,
particularly obligations already outstanding.
(5) The bill is inadequate; the excess of percentage depletion over
cost depletion and the excess of intangible drilling and development
expenses over the deductions allowed under straight line depreciation
should be added to the list of tax preference items subject to the limit
on tax preferences.
(6) The limit on tax preferences will discourage charitable gifts.
(Y) If Congress has seen fit to provide a specific tax benefit, there is
no reason why it should be denied to some merely on the ground that it,
in combination with other items, represents a large proportion of that
individual's income.
(8) Since this limit will not affect individuals until the sum of their
tax preference income equals one-half of their total income, it will still
be possible for some individuals to exclude substantial amounts of tax
preference income from tax.
H. ALLOCATION OF DEDUCTIONS
Present law. — Under present law an individual is permitted to
charge his personal or itemized tax deductions entirely against his
taxable income, without charging any part of these deductions to his
tax-free income.
49
Problem: — The fact that an individual who receives tax-free income
or special deductions can charge the entire amount of his personal
deductions to his taxable income in effect gives him a double tax benefit.
He not only excludes the tax-free income from his tax base but he also,
by charging all his personal deductions against his taxable income,
reduces his tax payments on this taxable income. As a result, individ-
uals with substantial tax-free income and special deductions and large
personal deductions can wipe out much or all of their tax liability
on substantial amounts of otherwise taxable income.
House solution. — The House bill provides that an individual must
allocate his personal deductions between his taxable income and his
tax preference items, to the extent that the latter exceed $10,000.
For example, a taxpayer whose income is divided equally between
his taxable income and his tax preference income is allowed to take
only one-half his otherwise allowable personal deductions; the re-
maining half of such personal deductions are disallowed.^
The personal expenses which must be allocated include interest,
taxes, personal theft and casualty losses, charitable contributions, and
medical expenses.
The tax preference items taken into account for this purpose are the
same as those included under the limit on tax preferences (see item
G) except for certain modifications. Tax-exempt interest on State and
local bonds issued before July 12, 1969, is not taken into account. In
addition, milike the limit on tax preferences, the allocation provision
includes in the list of tax preference items the excess of intangible
drilling expenses over the am'ount of the expenses which would have
been recovered through straight line depreciation and the excess of
percentage depletion over cost depletion.
Taxpayers apply the limit on tax preferences before allocating de-
ductions. Any tax preferences included in taxable income as a result
of the limit on tax preferences are treated as taxable income for pur-
poses of allocating deductions.
The allocation provision applies to years beginning after 1969, ex-
cept that in the first year to which it applies only one-half of the tax-
payer's personal expenses must be allocated.
Arguments For. — (1) The allocation of deductions provision is sup-
ported on the grounds that personal deductions are in fact paid for.
out of an individual's entire economic income and not just his taxable
income. For that reason the deduction should be allowed for these
items only to the extent the income to which they relate is included in
an individual's tax base.
(2) The allocation provision is specifically designed to minimize
any possible unfavorable impact on State and local obligations since
only interest on bonds issued in the future are taken into account and
this interest income is brought in under the allocation provision only
gradually over a 10-year period.
1 This example, in order to illustrate the allocation in a simple manner, takes all tax
preference income into account and, for allocation purposes, does not reduce such tax
preference income by $10,000 as under the bill.
50
(3) This provision helps correct the unfair discrimination in pres-
ent law which favors those taxpayers who derive their income from the
ownership of property as contrasted with those who earn their living
from wages and salaries.
(4) llie provision recognizes the desirability of a tax system in
Avhich no individual can avoid his fair share of the tax burden.
(5) The present tax improperly encourages investment of funds
in certain areas for tax considerations rather than good business rea-
sons and violates the principle that taxes should have a neutral impact
on economic decisions.
Arguments Against. — (1) The primary intent of the provision is to
tax tax-preferred income rather than disallowing deductions, It would
be better to consider the various tax-preference items individually and
to take whatever corrective action is necessary directly on those items.
(2) Enactment of a system which allocates deductions on the basis
of the relation between taxable and tax-preferred items of income
complicates the tax laws and adds considerable administrative difficul-
ties to the existing system.
(3) The bill raises a constitutional question as to the power of Con-
gress to tax (even indirectly) income from State and local government
obligations.
(4) Since most of the so-called "preferences" in today's law-
involves conscious decisions by Congress to encourage specific types
of investments, those provisions should not now be heedlessly diluted
under the guise of tax reform.
I. INCOME AVERAGING
Present law. — Under present law, income averaging permits a tax-
payer to mitigate the effect of progressive tax rates on sharp increases
in income. His taxable income in excess of 133% percent of his aver-
age taxable income for the prior 4 years generally can be averaged
and taxed at lower bracket rates than would otherwise apply. Certain
types of income such as long-term capital gains, wagering income,
and income from gifts are not eligible for averaging.
Problem. — The exclusion of certain types of income from income
eligible for averaging complicates the tax return and makes in difficult
for taxpayers to determine easily whether or not they would benefit
from averaging. In addition, taxpayers with fluctuating income from
these sources may pay higher taxes than taxpayers with constant
income from the same sources or fluctuating income from different
sources. Finally, the 1331/3 percent requirement denies the benefit of
averaging to taxpayers with a substantial increase in income and
reduces the benefits of averaging for those who are eligible.
House solution. — The House bill extends income averaging to long-
term capital gains, income from wagering, and income from gifts.
It also lowers the percentage by which an individual's income must
increase for averaging to be available from 33l^ percent to 20 percent.
Argwments For. — (1) Permitting averaging for presently excluded
income will result in simplification of the tax form and theaveraging
computation.
(2) In the case of capital gains, it is maintained that the 50 percent
exclusion does not provide a form of averaging because it does not
distinguish between taxpayers with fluctuating capital gains and those
with constant capital gains, and therefore averaging for capital gains
is appropriate.
51
(3) As the InternaJl Revenue Service lias worked -with the present
income averaging provisions, it has become apparent that the adminis-
trative limitation of 1331/3 percent may be relaxed to do more equity
for those cases where income averaging is appropriate.
Arguinents Against. — (1) Income should be accounted annually.
This provision enlarges the present opportunity for taxpayers to avoid
full taxation.
(2) The items excluded from averaging were excluded for good
reason. Capital gains already is given favorable treatment because
only 50 percent of the gains is taxed. Income from w^agering should
not be eligible for averaging because the receipt of such income should
not be encouraged. Income from gifts should not be eligible for aver-
aging since it does not result from any effort on the part of the.
taxpayer.
(3) The 133% percent requirement should not be reduced to 120
percent since this will allow averaging for unreasonably small in-
creases in income.
(4) Liberalization of income averaging rules for persons who ex-
perience a substantial increase in their earnings should be deferred
until income averaging rules are devised which will give relief to per-
sons who experience a sharp decline in their earnings.
J. RESTRICTED STOCK PLANS
Present law. — Present law does not contain any specific rules gov-
erning the tax treatment of restricted stock plans. Existing Treasury
regulations generally provide that no tax is imposed when the employee
receives the restricted stock. Tax is deferred until the time the restric-
tions lapse; at that time, only the value of the stock, determined at the
time of transfer to the employee, is treated as compensation, provided
the stock has increased in value. If the stock has decreased in value,
tlieii the lower amount at the time the restrictions lapse is considered
to be compensation. Thus, under present regulations there is a deferral
of tax with respect to this type of compensation and any increase in
the value in the stock between the time it is granted and the time when
the restrictions lapse is not treated as compeiisation.
Problem. — The present tax treatment of restricted stock plans is
significantly more generous than the treatment specifically provided
in the law for similar types of deferred compensation arrangements.
An example of this disparity can be seen by comparing the situation
where stock is placed in an employee's trust as opposed to the giving
of restricted stock directly to the employee. In the employee trust
situation, if an employer transfers stock to a trust for an employee
and the trust provides that the employee will receive the stock at the
end of 5 j^ears if he is alive at that time, the employee would be treated
as receiving, and would be taxed on, compensation in the amount of
the value of the stock at the time of the transfer. However, if the
employer, instead of contributing the stock to the trust, gives the stock
directly to the employe© subject to the restriction that it cannot be
sold for 5 years, then the employee's tax is deferred until the end of
the 5-year period. In the latter situation, the employee actually pos-
sesses the stock, and he can vote it and receive the dividends, yet his
52
tax is deferred. In the trust situation, he has none of these benefits, yet
he is taxed at the time the stock is transferred to the trust.
House solution. — The House bill provides that a person who receives
compensation in the form of property, such as stock, which is subject
to a restriction generally is subject to tax on the value of the property
at the time of receipt unless his interest is subject to a substantial risk
of forfeiture. In this case, he is to be taxed when the risk of forfeiture
is removed. The restrictions on the property are not taken into account
in determining its value except in the case where the restriction by its
terms will never lapse. Generally, this provision applies to property
transferred after June 30, 1969.
Argum-ents For. — (1) The House bill provision is supported on
the grounds that it eliminates the disparity of tax treatment between
various forms of deferred compensation by bringing restricted stock
plans within the rules that Congress set forth as being the appropriate
means by which an employee could be given a shareholder's interest
in the business.
(2) Restricted stock plans are essentially compensation to an execu-
tive for services rendered. They represent incentives to key employees,
and in many cases represent a significant portion of a taxpayer's total
compensation.
(3) The provision is needed to close a loophole through which
highly compensated employees are paid part of their compensation
under circumstances w^hereby tax can be put off until the employee is
in a lower tax bracket.
(4) The stock option rules provide sufficient opportunity for em-
ployees to receive an interest in their employers' business, yet, these
rules are undermined by the less stringent requirements of restricted
stock plans.
Arguments Against. — (1) The tightening of the rules on restricted
stock plans may discourage employees' stock ownership of their
employers' business.
(2) The bill would immediately tax the receipt of property which,
in many instances, cannot be sold or otherwise disposed of by the
taxpayer to pay the tax.
(3) The bill, in the case of forfeitable stock would tax capital
appreciation of the property as ordinary income.
(4) Restricted stock plans are not, in fact, deferred compensation
arrangements, but rather are a means of allowing key employees to
become shareholders in the business.
(5) It is necessary to have these preferred stock plans so as to
obtain and retain key employees.
(6) These tax incentives increase the economic productivity of
business ; hence, the benefits to everyone concerned are increased.
(7) Little revenue appears to be involved ; hence, there is no real
benefit accruing from making a change.
K. OTHER DEFERRED COMPENSATION
Present law and problem. — Under present law, the Internal Revenue
Service has allowed substantial tax benefits to be obtained with respect
to certain types of deferred compensation arrangements for key
employees. These arrangements are not required to meet the qualifica-
53
tions prescribed in the tax law for qualified pension and profit-sharing
plans, and they are often available only to highly paid employees.
Generally, under these arrangements, employees are permitted to defer
the receipt (and taxation) of part of their current compensation until
retirement, when they presumably will be in lower income tax
brackets.
The following example is typical of these arrangements: The
employer and the employee enter into a 5-year employment contract
which isrovides for a specified amount of current compensation and
an additional specified amount of nonforfeitable deferred compensa-
tion. The deferred compensation is credited to a reserve account on
the company books. It is accumulated and paid in equal annual install-
ments in the first 10 years after the employee's retirement.
Deferral is available only with respect to unfunded arrangements.
In the case of funded arrangements (that is, where the employee has
an interest in property) , the employee is taxed currently on the contri-
bution (provided his rights are nonforfeitable) even though he can-
not immediately receive it. There is no tax deferral, and the tax
imposed on the additional compensation is determined by reference
to the employee's current tax bl-acket.
House sohition. — The bill provides that the tax on deferred com-
pensation is to continue to be deferred until the time the compensa-
tion is received, but that a minimum tax is to be imposed on deferred
compensation received in any year in excess of $10,000. Generally,
this minimum tax is the total increase in tax which would have
resulted if the deferred compensation had been included in the tax-
))ayer's income in the years in which it was earned. This provision
does not apply to any nondiscriminatory pension or profit-sharing
plan (whether funded or unfunded) . Generally, this provision applies
only to the j^ortion of deferred compensation payments attributable
to years beginning after 1969.
Arguments For. — (1) Tliis provision is supported on the basis that
the employee who receives deferred compensation has received, in most
cases, a valuable contractual right on which an immediate tax could
be imposed, and the bill represents a reasonable compromise between
immediate taxation and complete deferral. The payment of the tax is
deferred until the compensation is actually received, but the original
marginal rate is preserved as a minimum rate.
(2) The tax treatment of deferred compensation should not depend
on whether the amount to be deferred is placed in trust or whether it is
merely accumulated as a reserve on the books of the employer corpora-
tion, because an unfunded promise by a large, financially established
corporation is probably as sufficiently sound as the amount of deferred
compensation which is placed in trust. Usually these benefits are not
available to the average employee-taxpayer.
(3) The possibility of shifting income from high-bracket years to
low-bracket years after retirement is generally available only to
high-bracket and managerial employees who are in a financial posi-
tion to demand them — not to the average employee.
(4) Another provision of this bill reduces maximum tax on earned
income to 50 percent. With this lower rate, the incentive to seek de-
ferral is lessened and the special tax treatment of deferred compensa-
tion can be ended without harsh consequences.
54
Arguments Against. — (1) Deferred compensation arrangements
benefit small and medium sized companies who face economic uncer-
tainties and possible future financial difficulties. This type of arrange-
ment enables management to have a financial interest in the business
enterprise, while at the same time it allows the company to have the
use of the funds involved.
(2) Income should be taxed at the tax rates which apply to the year
in which the income is received.
(3) The primary benefit of deferred compensation is forward aver-
aging ; that is, the employee is able to level out his income by shifting
earnings from peak years to retirement years when he expects his other
income to be lower. Forward averaging is not tax avoidance and there
is no reason to prevent it.
(4) This provision will be difficult to administer.
(5) Deferred compensation benefits should be preserved as an incen-
tive to executives.
L. ACCUMULATION TRUSTS, MULTIPLE TRUSTS, ETC.
Present lata. — A trust that distributes all its income currently to its
beneficiaries is not taxed on this income; instead the beneficiaries in-
clude these distributions in their income for tax purposes.
An accumulation trust (a trust where the trustee is either required,
or is given discretion to accumulate income for future distributions to
beneficiaries) , however, is taxed on its accumulated income at individ-
ual rates. When this accumulated income is distributed to the benefi-
ciaries, in some cases they are taxed on the distributions under a
so-called throwback rule. The throwback rule treats the income for
tax purposes as if it had been received b}[ the beneficiary in the year
in which it was received by the trust. This throwback rule, however,
only applies on the part of the distribution of accumulated income
which represents income earned by the trust in the 5 years immedi-
ately prior to the distribution. In addition to this limitation, the
throwback rule does not apply to certain types of distributions.
Problem. — The progressive tax rate structure for individuals is
avoided when a grantor creates trusts which accumulate income taxed
at low rates, and the income in turn is distributed at a future date with
little or no additional tax being paid by the beneficiary. This result
occurs because the trust itself is taxed on the accumulated income rather
than the grantor or the beneficiary. This means that the income in
question, instead of being added on top of the beneficiary's other in-
come and taxed at his marginal tax rate, is taxed to the trust at the
starting tax rate. The throwback rule theoretically prevents this re-
sult, but the 5-year limitation and the numerous exceptions substan-
tially limit the effectiveness of the rule.
This avoidance device is compounded by the use of multiple trusts —
the creation of more than one accumulation trust by the same grantor
for the same beneficiary.
House solution. — The bill provides that in the case of accumulation
trusts (including multiple trusts) the beneficiaries are to be taxed on
distributions of accumulated income in substantially the same manner
as if the income had been distributed to the beneficiaries when it was
earned by the trust. The taxes paid by the trust on the income, in
55
effect, will be considered paid by the beneficiary for this purpose. A
shortcut method of computing the tax on the distribution of accumu-
lated income is provided under which the tax attributable to the dis-
tribution, in effect, is averaged over the number of years in which the
income was earned by the trust. Distributions of income accumulated
by a trust (other than a foreign trust created by a U.S. person) in
years ending before April 23, 1964, are not subject to the new un-
limited throwback rule. This provision applies to the distributions
made after April 22, 1969.
The bill also provides that in the case of a trust created by a tax-
payer for the benefit of his spouse, the trust income which may be used
for the benefit of the spouse is to be taxed to the creator of the trust
as it is earned. Tliis provision is to apply only in respect to property
transferred in trust after April 22, 1969.
Argutnents For. — (1) The bill prohibits the avoidance of the effect
of the progressive tax rates where a grantor creates a trust or multiple
trusts, which accumulate income, pay tax on such income at a much
lower rate than would the beneficiary and then distribute it to him at
a later date with little or no additional tax being paid by the bene-
ficiary, even though he may be in a high tax bracket.
(2) Under the present law, the Internal Revenue Service has been
unable to successfully resolve the problems presented by the use of
multiple trusts. In some cases the courts have upheld the validity of
such trusts.
(3) Accumulation trusts will be placed in substantially the same
tax status as beneficiaries of trusts which distribute their income
currently,
(4) This approach provides essentially the same treatment as has
been applicable to foreign accumulation trusts created by U.S. persons
since the pasage of the Revenue Act of 1962.
Arguments Against. — (1) These provisions would be extremely
difficult to administer and enforce by the Internal Revenue Service and
on the part of the trustees.
(2) The abuse in this area involves multiple trusts and it is harsh
to correct it in a way that upsets the normal fiduciary use of accumula-
tion trusts.
(3) This provision will result in harsh tax consequences in the case of
accumulation trusts which were established for nontax reasons, such
as to postpone the receipt of funds by the beneficiary until he had
reached a responsible age.
M. MULTIPLE CORPORATIONS
Present Jaw. — There are several ]3rovisions in the code which are
designed to aid small corporations. The most important of these pro-
visions is the surtax exemption. As the result of the surtax exemption
corporations are taxed at only 22 percent, instead of at 48 percent on
the first $25,000 of taxable income.
Present law permits a controlled group of corporations to each
obtain a $25,000 surtax exemption if each of the corporations pays an
additional 6 percent tax on the first $25,000 of taxable income.'^ This
1 The election to take multiple surtax exemptions and to pay the additional 6 percent tax
is generally desirable where the group has a combined income of about $32,500 or more.
Below this figure the allocation of a single surtax generally produces a lower tax.
56
generally reduces the tax savings of the surtax exemption from $6,500
to $5,000.
Other provisions in the code designed to aid small corporations
include: (1) the provision which allows a corporation to accumulate
$100,000 of earnings without being subject to the penalty tax on
earnings unreasonably accumulated to avoid the dividend tax on
shareholders; and (2) the provision which allows an additional first
year depreciation deduction equal to 20 percent of the cost of the
property (limited to $10,000 per year) .
Problem. — Large corporate organizations have been able to obtain
substantial benefits from these provisions by dividing income among
a number of related corporations. Since these are not in reality "small
businesses'" it is difficult to see why they should receive tax benefits
intended primarily for small business.
House solution. — The House bill provides that a group of controlled
corporations may have only one of each of the special provisions de-
signed to aid small corporations. A controlled group of corporations is
limited to one $25,000 surtax exemption and $100,000 accumulated
earnings credit after an 8-year transition period. This is accomplished
by gradually reducing the amount of the special provisions in excess of
one which is presently being claimed by a controlled group over the
years 1969 to 1975 until these excess special provisions are reduced to
zero for 1976 and later years. The limitation on multiple benefits from
the investment credit and first year additional depreciation, becomes
fully effective with taxable years ending on or after December 31,
1969.
To ease the transition, controlled corporations are allowed to increase
the dividend received deduction from 85 percent to 100 percent at a
rate of 2 percent per year. In addition, controlled corporations who
elect to file consolidated returns, may deduct net operating losses for a
taxable year ending on or after December 31, 1969, against the income
of other members of such group. Present regulations allow such losses
to be deductible only against the income of the corporation which sus-
tained the losses.
The bill also broadens the definition of a controlled group of
corporations.
Arguments For. — (1) Large economic units have been able to reap
unintended tax benefits through the use of multiple corporations.
Often the only reason for using multiple corporations is to take ad-
vantage of the surtax exemption or the $100,000 accumulated earn-
ings credit. This may lead to uneconomic practice and a great waste
of energy by taxpayers, their counsel, and the Internal Revenue Serv-
ice. By structuring a large economic unit so as to generate no more
than $25,000 of taxable income in each component corporation, the
maximum marginal tax can be held at 28 percent instead of 48 per-
cent, thus, avoiding tax of $5,000 for each corporation.
(2) Even where there are good business reasons for using multiple
but related corporations they still should not be given the tax benefits
designed for small business.
(3) This provision will prevent the artificial incorporation of many
companies that actually perform the same or similar operations under
one management.
57
(4) Under the, present law, large businesses, such as various chain
stores, are able to take advantage of the multiple surtax exemption
while competing smaller businesses in local communities are not. This
presents an element of unfair competition which the bill eliminates.
Arguments Against. — (1) The repeal of the multiple surtax exemp-
tion would discourage legitimate and normal expansion of growling
businesses within a controlled group which is established for sound
business purposes.
(2) Multiple corporate structures arise for bona fide business rea-
sons and not for tax reductions. Such corporations are formed to
limit public liability, to comply with State requirements and to
"tailor" themselves to the particular business operation involved. The
tax law should not penalize these legitimate purposes.
(3) A new venture is often unprofitable in the early operation. By
placing the new venture in a separate coriX)ration, the losses can
be recouped faster via the $25,000 surtax exemption and the other
benefits allowed.
(4) No competitive unfairness exists within the industries, some of
Avhose members ha^'e traditionally been organized into separate
corporations.
N. CORPORATE MERGERS
1. Disallowance of Interest Deduction in Certain Cases
Present law. — Under present law a corporation is allowed to deduct
interest paid by it on its debt but is not allowed a deduction for divi-
dends paid on its stock or equity.
Problem. — It is a difficult task to draw^ an appropriate distinction
between dividends and interest, or equity and debt. Although this
problem is a long-standing one in the tax laws, it has become of in-
creasing significance in recent years because of the increased level of
corporate merger activities and the increasing use of debt for cor-
porate acquisitions purposes.
There are a number of factors which make the use of debt for
corporate acquisition purposes desirable, including the fact that the
acquiring company may deduct the interest on the debt but cannot
deduct dividends on stock. A number of the other factors which make
the use of debt desirable are also the factors which tend to make a
bond or debenture more nearly like equity than debt. For example,
the fact that a bond is convertible into stock tends to make it more
attractive since the convertibility feature will allow the bondholder
to participate in the future growth of the company. The fact that
debt is subordinated to other creditors of the corporation makes it
more attractive to the corporation since it does not impair its general
credit position.
Although it is possible to substitute debt for equity without a merger,
this is much easier to bring about at the time of the merger. This is
because, although stockholders ordinarily would not be willing to
substitute debt for their stock holdings, they may be willing to do
so pursuant to a corporate acquisition where they are exchanging their
holdings in one company for debt in another (the acquiring) company.
In summary, in many cases the characteristics of an obligation is-
sued in connection with a corporation acquisition make the interest
58
in the corporation which it represents more nearly like a stockholder's
interest than a creditor's interest, although the obligation is labeled as
debt.
House solution. — In general, the bill disallows a deduction for in-
terest on bonds issued in connection with the acquisition of a cor-
poration where the bonds have specified characteristics which make
them more closely akin to equity.
The disallowance rule of the bill only applies to bonds or deben-
tures issued by a corporation to acquire stock in another corporation
or to acquire at least two-thirds of the assets of another corporation.
Moreover, the disallowance rule only applies to bonds or debentures
which have all of the following characteristics: (1) they are sub-
ordinated to the corporation's trade creditors; (2) they are conver-
tible into stock; and (3) they are issued by a corporation with a ratio
of debt to equity which is greater than two to one or with an annual
interest expense on its indebtedness which is not covered at least three
times over by its projected earnings.
An exception to the treatment provided by the bill is allowed for
up to $5 million a year of interest on obligations which meet the pre-
scribed test.
This provision of the bill also does not apply to debt issued in tax-
free acquisitions of stock of newly formed or existing subsidiaries,
or in connection with acquisitions of foreign corporations if substtan-
tially all of the income of the foreign corporation is from foreign
sources.
This provision applies to interest on indebtedness incurred after
May 27, 1969.
Arguments For. — (1) This provision helps stem the tide of con-
glomerate mergers, which have increased phenomenally in recent years
and which pose a threat to our economic well-ibeing, by denving the
interest deduction with respect to certain types of indebtedness in-
curred by corporations in acquiring the stock of other entities.
(2) The corporate bonds and debentures used in conglomerate ac-
quisitions have characteristics, such as convertibility and subordina-
tion, which delineate the interest in the corporation which they repre-
sent more as equity than as de<bt. This bill properly treats them as
equity interests.
(3) Advantageous tax provisions have spurred the "urge to merge"
with the result that the Federal Government bears a portion of lihe
carrying costs of many conglomerate acquisitions. This provision with-
draws one of those advantages.
Arguments Against. — (1) Mergere are part of the American busi-
ness complex. They represent growth and, in many instances, rejuve-
nate businesses and management, and nurture higher degrees of effi-
ciency and competence.
(2) Deibentures and bond issues represent debt in the business com-
munity and they should not be characterized as equity interests for
tax purposes.
(3) If Congress desires to inhibit the merger movement, it should
make all reorganizations taxable events — regardless of whether they
are voluntary or involuntary, horizontal, vertical or pure conglomerate.
G^ngress should not limit its examination to the tax treatment of con-
glomerate mergers, but Should also consider those sections of the Code
59
which permit hosts of corporate mergers to proceed unburdened by
any taxation.
(4) The increasing amount of debt used for Corporation acquisition
purposes and the economic implications of the merger trend warrant
a broader approach tlian that embodied in the bill (i.e., a broader dis-
allowanc-e of the interest deduction) .
(5) If this rule is appropriate in the case of acquisitions it also is
appropriate where similar "debt" is issued for other purposes.
2. Limitation on Installment Sales Provision
Present law. — Under present law^, a taxpayer may elect the install-
ment method of reporting a gain on a sale of real pi-operty, or a casual
sale of personal property where the price is in excess of $1,000. The
installment method, however, is available only if the payments received
by the seller in the year of sale (not counting debt obligations of the
purchaser) do not exceed 30 percent of the sales price.
Although the Internal Revenue Service has not ruled as to whether
the installment method of reporting gain is available where the seller
receives debentures, it is understood that some tax comisel have ad-*
vised that the method is so available.
Problem. — ^The allowance of the installment method of reporting
gain where debentures are received by a seller of property may result
in long-term tax deferral which nearly approacnes nonrecognition,
rather than installment reporting. In other words, the gain on the
debentures need not be reported until they mature, which may not be
until 15 or 20 years later.
Moreover, the allowance of the installment method where debentures
or other readily marketable securities are received by the seller of prop-
erty is not consistent with the purpose for which the installment pro-
vision was adopted. This method presumably was initially made avail-
able because of the view^ that where a seller received a debt obligation
he did not have cash, or the equivalent of cash, on hand wiiich would
provide him with f mids to pay the tax due on the gain. This problem,
however, does not exist where the seller receives readily marketable
securities.
Present law is also unclear as to the number of installments which
are required if a transaction is to be eligible for the installment sales
provision. In other words, it is not clear whether the installment
method may be used when there is only one or a limited number of
payments which may be deferred for a long time.
House solution. — The bill places two limitations on the use of the
installment method of reporting gain on sales of real property and
casual sales of personal property.
First, bonds with interest coupons attached, in registered form, or
which are readily tradable, in effect, are to be considered payments in
the year of sale for purposes of the rule which denies the installment
method where more than 30 percent of the sales price is received in
that year.
The second limitation provided by the bill would deny the use of the
installment method unless the payment of the loan principal, or the
payment of the loan principal and the interest together, are spread
relatively evenly over the installment period. This requirement would
33-158 O— 69-
60
be satisfied if at least 5 percent of the loan principal is to be paid by
the end of the first quarter of the installment period, 15 percent is to
be paid by the end of the second quarter, and 40 percent is to be paid
by the end of the third quarter.
This provision applies to sales after May 27, 1969.
Arguments For. — (1) In view of the increase in merger activities
in recent years, this provision is necessary, alon^ with the other
provisions relating to interest and original issue discounts, to with-
draw tax incentives to merge.
(2) The limitations provided by this provision on the use of the
installment sales method resitrict the availability of the method to
situations which are consistent with the purposes for which the in-
stallment method was adopted. In other words, a seller is treated as
receiving cash w^hen he receives something which is the equivalent
of cash. In addition, a sale which involves a deferred payment, rather
than installments, is not to be treated as an installment sale,
(3) The bill improves on the present law where ambiguitj exists
as to the number of installment payments which are required m order
for a transaction to qualify for installment sale treatment. It sets
forth the specific criteria to be followed.
Arguments Against. — (1) Tlie present law relating to installment
sales is clear enough to prevent any abuse. Where there is a trans-
action which provides for payment in installments, installment sales
treatment should be allowed if it complies with the terms of the present
law.
(2) The installment privilege should be available even where the
ddbt instrument is readily marketable or where the payments are not
spread relatively evenly over the period the debt is outstanding.
3. Original Issue Discount
Present law. — Under present law, original issue discount arises
when a corporation issues a bond for a price less than its face amount.
(The amount of the discount is the difference between the issue price
and the face amount of the bond.) The owner of the bond is not taxed
on the original issue discount until the bond is redeemed or until he
sells it, whichever occurs earlier. In addition, only that portion of
the gain on the sale of the bond equal to the part of the original issue
discount attributable to the period the taxpayer has held the bond
is taxed at ordinary income rates.
The corporation issuing the bond, on the other hand, is allowed to
deduct the original issue discount over the life of the bond.
Problem. — Present law results in a nonparallel treatment of
original issue discount between the issuing corporation and the bond-
holder. The corporation deducts a part of the discount each year.
On the other hand, the bondholder is not required to report any of
the discount as income until he disposes of \h<A bond. Although it is
likely that the discount will be deducted by the corporation, it is
probable that much of the ordinary income is not being reported by
the bondholders.
House solution. — The bill generally provides that the bondholder
and the issuing corporation are to be treated consistently with respect
to original issue discount. Thus, the bill generally requires a bond-
holder to include the original issue discount in income ratably over
61
the life of the bond. This rule applies to the original bondholder as
well as to subsequent bondholders.
Corporations issuing bonds in registered form would be recjuired to
furnish the bondholder and the Government with an annual informa-
tion return regarding the amount of original issue discount to be
included in income for the year.
The bill also clarifies present law by providing that original issue dis-
count may arise when a bond is issued in exchange for stock or other
property.
This provision does not apply to bonds issued by a government or a
political subdivision.
This provision applies to bonds issued on or after May 28, 1969.
Arguments For. — The present law encourages the use of bonds to
acquire another corporation because where original issue discount is
involved, the tax treatment between the issuing corporation and the
person acquiring the bond is nonparallel — both receive a tax benefit.
This provision would eliminate the tax benefit to the bond holder,
discouraging the use of bonds in corporate mergers.
(2) The provision minimizes the possibility that original issue dis-
count will never be taxed to the bondholder.
Arguments Against. — (1) The present law is adequate in the treat-
ment of original issue discount and this provision at best, is an artifi-
cial way to discourage corporate mergers.
(2) A bondholder should not be taxed on orginal issue discount
until the time when he, in effect, receives it ; namely, when the bond is
redeemed or when he sells the bond.
4. Convertible Indebtedness Repurchase Premiums
Present law. — Under present law, there is a question as to whether a
corporation which repurchases its convertible indebtedness at a pre-
mium may deduct the entire difference between the stated redemption
price at maturity and the actual repurchase price. The Internal Reve-
nue Service takes the position that the deduction is limited to an amount
which represents a true interest expense (i.e., the cost of borrowing)
and does not include the amount of the premimn attributable to the
conversion feature. This part of the repurchase is viewed by tlie Reve-
nue Service as a capital transaction analogous to a corporation's re-
purchase of its own stock for which no deduction is allowable. There
IS, however, a court case which holds to the contrary in that it allowed
the deduction of the entire premium. In addition, court cases have been
filed by taxpayers to test the validity of the Service's position on this
matter.
Problem. — A corporation which repurchases its convertible in-
debtedness is, in part, repurchasing the right to convert the bonds into
its stock. Since a corporation may not deduct the costs of purchasing
its stock as a business expense, it would apj^ear that the purchase of
what, in effect, is the right to purchase its stock should be treated in
the same manner.
House solution. — The bill provides that a corporation w^hicli repur-
chases its convertible indebtedness at a premium may deduct only that
part of the premium which represents a cost of borrowing rather than
being attributable to the conversion feature. Generally, the deduction
62
would he limited to a normal call premium for nonconvertible cor-
porate debt except where the corporation can satisfactorily demon-
strate that a larger amount of the premium is related to the cost of
borrowing.
This provision generally applies to repurchases of convertible in-
debtedness after April 22, 1969.
Arguments For. — (1) This provision resolves the conflict between
the Internal Revenue Service and the courts as to the amount of de-
ductible interest expense allowable where a corporation repurchases
its convertible indebtedness at a premium.
(2) This provision, in effect, treats a premium paid on the repur-
chase of convertible indebtedness as consisting of two elements, an
interest cost and an amount paid for the right to purchase stock.
It is appropriate to treat the amount paid for the right to purchase
stock in the same manner as an amount paid for stock (i.e., no
deduction is allowed for the amount) .
Argument Against. — The premium, although it may not in its
entirety be an interest expense, is an expense of carrying on a cor-
poration's Itrade or business for which a deduction should be allowed.
0. STOCK DIVIDENDS
Present lam. — In its simplest form, a stock dividend is commonly
thought of as a mere readjustment of the stockholder's interest, and
not as income. For example, if a corporation with only common
stock outstanding issues more common stock as a dividend, no basic
change is made in the position of the corporation and its stockholders.
No corporate assets are paid out, and the distribution merely gives
each stockholder more pieces of paper to represent the same interest
in the corporation.
On the other hand, stock dividends may also be used in a way that
alters the interests of the stockholders. For example, if a corporation
with only common stock outstanding declares a dividend payable, at
the election of each stockholder, either in additional conmion stock
or in cash, the stockholder who receives a stock dividend is in the
same position as if he received a taxable cash dividend and purchased
additional stock with the proceeds. His interest in the corporation is
increased relative to the interests of stockholders who took dividends
in cash. Under present law, the recipient of a stock dividend under
these conditions is taxed as if he had received cash.
Problem. — In recent years, considerable ingenuity has been used in
developing methods of capitalizing corporations in such a way that
shareholders can be given the equivalent of an election to receive cash
or stock, but at the same time permitting stockholders who choose
stock dividends to receive them tax free. Typically, these methods
involve the use of two classes of common stock, one paying cash
dividends and the other stock dividends. Sometimes, by means of such
devices as convertible securities with changing conversion ratios, or
systematic redemptions, the effect of an election to receive cash or
stock can be achieved without any actual distribution of stock divi-
dends, and therefore without any current tax to the stockholders
whose interests in the corporation are increased.
63
House solution. — The bill provides that a stock dividend is to be
taxable if one group of shareholders receives a distribution in cash and
there is an increase in the proportionate interest of other shareholders
in the corporation. In addition, the distribution of convertible pre-
ferred stock is to be taxable unless it does not cause such a dispropor-
tionate distribution.
To counter the various devices by which the effect of a distribution
of stock can be disguised, the bill gives the Treasury Department
regulatory authority to treat as distributions changes in conversion
ratios, r^emptions, and other transactions that have the effect of
disproportionate distributions.
The bill also deals with the related problem of stock dividends on
preferred stock. Since preferred stock characteristically pays specified
cash dividends, all stock dividends on preferred stock (except anti-
dilution distributions on convertible preferred stock) are a substitute
for cash dividends, and all stock distributions on preferred stock
(except for antidilution purposes) are taxable under the bill.
These provisions apply (subject to certain transitional rules) to
distributions after January 10, 1969.
Arguments For. — (1) This provision is supported on the basis that
if a corporation in effect were permitted to offer bo-th growth stock and
current income stock to investors, the taxation of dividends at ordinary
income rates would be seriously undermined, and there would be a
substantial loss of revenue, exceeding $1.5 billion a year. If this option
were clearly permitted by statute, it is argued that most publicly held
corporations would establish two classes of stock, one cash-dividend-
paying stock and the other growth stock. The cash paying stock would
tend to be held by exempt organizations and taxpayers in low tax
brackets, and the growth stock would tend to be held by taxpayers in
high brackets. The holders of the growth stock would normally realize
their gains as capital gains (or without tax, if held until death).
(2) Giving investors the option to take taxable cash dividends or to
l^ermit earnings to accumulate without tax payment (but with a rela-
tive increase in the investor's equity interest) would provide them an
option not available to those receiving earned income.
(3) By permitting corporations unlimited discretion to pattern their
securities to fit various special situations, the present law facilitates
the takeover of businesses and the growth of conglomerate enterprises.
(4) Existing regulations (promulgated January 10, 1969) fail to
prevent all arrangements by which taxable cash dividends can be
paid to some shareholders while others enjoy a tax-free increase in
their proportionate ownership interest in the corporation.
Arguments Against. — ( 1 ) Stockholders should be allowed the choice
of taking down taxable dividends or leaving the corporation's earn-
ings to accumulate and thereby mcreasing their equity in the corpora-
tion. A corporation that gave mvestors this choice would find it easier
to raise capital, both by broadening its appeal to investors and by de-
creasing the amount it pays out in dividends. Under present law,
investors have the option to delay tax on investment earnings by in-
vesting m growth stocks that pay" little or no dividends, although this
choice is limited insofar as the corporation is concerned, since it must
generally choose to offer its investors either growth or current income.
64
(2) The bill imposes a tax on common stockholders even in situa-
tions where their proportionate interests decline (or at least do not
increase) because of the changing redemption or conversion rates
attached to preferred stock.
P. FOREIGN TAX CREDIT
Present law. — ^Under present law a U.S. taxpayer is allowed a for-
eign tax credit against his U.S. tax liability on foreign income. Gen-
erally, the amount of the credit is limited to the amount of U.S. tax
on the foreign income.
There are two alternative formulations of the limitation on the
foreign tax credit: the "per country" limitation and the "overall"
limitation. Under the per country limitation, foreign taxes and income
are considered on a country by country basis. Under the overall limita-
tion, on the other hand, all foreign taxes and foreign income are
aggregated.
Thus, under this limitation, foreign taxes in one country, in effect,
can be averaged with lower foreign taxes in another foreign country.
Prohlem. — A. Foreign Losses :
The per country limitation allows a U.S. taxpayer with losses
in a foreign country to , in effect, obtain a double tax benefit.
Since the limitation is computed separately for each foreign country,
the losses reduce U.S. tax on domestic income, rather than reducing the
credit for taxes paid to other foreign countries (as would occur under
the overall limitation). When the business operation in the loss coun-
try becomes profitable, the income, in effect, is likely not to be taxed
by the United States because a foreign tax credit is allowed with
respect to that income.
Prolylerrh. — B. Foreign Tax-Royalties:
Another problem which may arise under either limitation (but
which primarily arises under the overall limitation) is the difficulty
of distinguishing royalty payments from tax payments. This problem
especially arises in cases where the taxing authority in a foreign coun-
try is also the owner of mineral rights in that country. Since royalty
payments may not be credited against U.S. taxes, the allowance of a
foreign tax credit for a payment which, although called a tax, is in fact
a royalty, allows a taxpayer a larger credit than he should receive.
Wliere the credit exceeds the U.S. tax on the income from the mineral
production in the foreign country, the excess credit may be used to
offset U.S. tax on income from other operations in that country, or on
income from other foreign countries.
House solution. — The bill provides two additional limitations on
the foreign tax credit.
A. Foreign Losses :
First, a taxpayer who uses the per country limitation, and who re-
duces his U.S. tax on U.S. income by reason of a loss from a foreign
country, is to have the resulting tax benefit recaptured when income is
subsequently derived from the country. This is accomplished by tax-
ing subsequent income from that country until, in effect, the previous
tax benefit is recaptured (i.e., until tax has been imposed on an amount
of income equal to the amount of the loss previously deducted from
65
U.S. income) . (Generally, the amount of the benefit recaptured in any
one year is limited to one-half the U.S. tax which would have been im-
posed on the income from the foreign country for that year, in the
absence of the foreign tax credit. The amount of the tax benefit nc»t
recaptured in a year because of this limitation would be recaptured in
subsequent years. Tlie bill also applies the recapture rule where the
taxpayer disposes of property which was used in the trade or business
from which the loss arose. In this case, the amount of the loss not
previously recaptured is included in income when the property is
disposed of.
B. Foreign Tax-Royalties:
The bill also provides a separate foreign tax credit limitation in the
case of foreign mineral income so that excess credits from this source
cannot be used to reduce U.S. tax on other foreign income. In other
words, the foreign tax credit allowed on mineral income from a foreign
country will be limited to the amount of U.S. tax on that income. Ex-
cess credits may be carried over under the normal foreign tax credit
carryover rules and credited against U.S. tax in other years on foreign
mineral income. This separate limitation applies (1) where the foreign
country from which the mineral income is derived requires the pay-
ment of a royalty with respect to the income producing property, (2)
where that country has substantial mineral rights in the income pro-
ducing property, or (3) where that country imposes higher taxes on
mineral income than on other income. The purpose of these criteria is
to isolate these cases in which it is likely that the taxes, at least in part,
represent royalties. This separate limitation does not apply where a
taxpayer's foreign mineral income for a year is less than $10,000.
The loss recapture rule applies to losses in years after 1969 and the
separate foreign tax credit limitation on foreign mineral income ap-
plies to years beginning after the enactment of the bill.
A. Foreign Losses :
Arguynent For. — The foreign tax credit was designed to prevent
the same income from being subjected to a double tax — once by the
foreign country where the income was earned and a second time by
this country; it was not intended to allow a double tax benefit, for
example, where a foreign loss prevents the application of both foreign
and domestic taxes on other domestic income. The amendment is needed
to correct this loophole.
Argimient Against. — ^This provision will tend to discourage new
ventures by United States corporations in foreign countries.
B. Foreign Tax-Royalties:
Arguments For. — (1) Where a foreign government owns mineral de-
posits it makes little difference to the foreign government whether it
demands royalties from the companies developing the deposits or
assesses high taxes on the income they earn from those mineral de-
posits. For U.S. tax purposes, however, it is important that payments
to a foreign government with respect to mineral deposits owned by that
government be designated as a "tax" since foreign taxes are creditable
against U.S. taxes while "royalties" are not. This amendment is needed
to prevent these payments which may largely represent a "royalty"
from being designated as "foreign taxes" in order to gain a U.S. tax
advantage.
66
(2) The bill is desirable in that it recognizes the significant diffi-
culties of ascertaining whether a payment labeled as a tax payment is,
in fact, a tax or a royalty by limitmg the major abuse which arises in
this area, namely the use of excess foreign tax credits on mineral in-
come to offset U.S. tax on other foreign income.
Arguments Against. — (1) A United States taxpayer with foreign
mineral operations should not be penalized as compared to other U.S.
taxpayers with other types of operations ; if a foreign government im-
poses an income tax it should uniformly be treated as income tax for
foreign tax credit purposes.
(2) Just because it is "difficult" to distinguish a true royalty and a
tax is no reason to treat that portion of a "tax payment" made to a
foreign government with respect to a mineral deposit it owns which is
a true "tax" any less favorably than any other tax ; by subjecting the
entire payment to a separate limitation mineral taxes paid to a foreign
government are discriminated against.
(3) The bill places further obstacles before U.S. companies compet-
ing with companies of other nations for the right to develop and con-
trol mineral production abroad; this hurts our balance of payments
and can affect the share of worldwide oil reserves available to the free
world.
(4) The general nature of the separate limitation on foreign mineral
income may have the effect of denying a foreign tax credit for part of
a tax payment even where no amount of the tax payment is, in fact, a
royalty.
Q. FINANCIAL INSTITUTIONS
1. Commercial Banks — Reserves for Losses on Loans
Present law. — Commercial banks, as a result of Revenue Ruling
65-92 (C.B. 1965-1, 112), now have the privilege of building up a
bad debt reserve equal to 2.4 percent of outstanding loans not insured
by the Federal Government. The 2.4-percent figure used for this pur-
pose is roughly three times the annual bad-debt loss of commercial
banks during the period 1928^7. In 1968, Revenue Ruling 68-630
(C.B. 1968-2, 84) clarified the loan base used for computing the allow-
able bad-debt reserve to include only those loans on which banks can
suffer an economic loss.
Problem. — By allowing commercial banks to build up bad-debt re-
serves equal to 2.4 percent of uninsured outstanding loans, present law
gives them much more favorable treatment than most other taxpayers.
Section 166(c) of the Internal Revenue Code permits business tax-
payers to take a deduction for a reasonable addition to a reserve for bad
debts. Most taxpayers accumulate a bad-debt reserve equal to the ratio
of the average year's losses to accounts receivable. The average loss is
computed on the basis of losses for the current year and the 5 preceding
years.
Commercial banks have the option of establishing their bad-debt re-
serves on the basis of their actual experience like other taxpayers. How-
ever, they generally elect to build up these reserves on the basis of the
industrywide 2.4-percent figure permitted by Revenue Ruling 65-92.
The extent of the favored tax treatment granted to commercial banks
by this ruling is shown by the fact that if banks were subject to the
same bad-debt reserve rules applying to taxpayers generally, they
67
would on the average be allowed to build up a bad-debt reserve of less
than 0.2 percent of outstanding noninsured loans.
House solution. — The House bill provides that in the future the
deduction allowed commercial banks for additions to bad debt reserves
is to be limited to the amount called for on the basis of their own
experience as indicated by losses for the current year and the 5 pre-
ceding years. Banks with bad debt reserves in excess of the amount
allowable on the basis of their own experience (as of the close of the
last taxable year beginning before July 11, 1969) will not be required
to reduce these reserves. However, these banks will not be permitted to
add to reserves until additions are justified on the basis of their own
experience; and if such additions to reserves are not so justified they
will be allowed in effect to deduct only actual bad-debt losses.
To provide an extra margin of safety to protect against the pos-
sibility of unusually large bad-debt losses, banks will be permitted to
carry back net operating losses for 10 years instead of 3 years as under
present law. In addition, commercial banks will be permitted, as under
present law, to carry forward net operating losses for 5 years.
These provisions apply to years beginning after July 11, 1969.
Arguments for. — (1) The present bad debt reserves of commercial
banks based on the 2.4-percent industrywide figure are in excess of the
reserves needed in anything other than a catastrophic depression such
as occurred in the early 1930's.
(2) The more generous loss carrybacks provided by the House bill
should provide substantial protection to banks in the event of unusual
losses.
(3) The administratively determined 2.4 percent formula is based
generally on depression losses and ignores the many government poli-
cies since 1933, all designed to prevent a repetition of the financial
chaos of that era. In light of these policies and in view of favorable
banking experience since the depression, the present tax reduction for
loss reserves is unreasonably generous.
Arguments Against. — ( 1 ) Banks should be encouraged to take every
possible precaution, including the creation of adequate reserves, to
assure depositors that their money is safe and that they will be able
to protect against depression- scale losses. Witliout such assurance, con-
fidence in the financial system could be threatened.
(2) Extension of the period for carrying bank losses back is no
substitute for the strength and solvency which depression-related
reserves convey, not only domestically, but in international financial
circles as well.
2. Mutual Savings Banks, Savings and Loan Associations, etc.
Present law. — Mutual savings banks, savings and loan associations,
and cooperative banks are permitted to compute additions to their
bad-debt reserves on the basis of their actual experience or under one
of two alternative formulas (specified by the 1962 Revenue Act),
whichever produces the greatest addition to the reserve. The two
alternative formulas provide for the deduction of (1) 60 percent of
taxable income, or (2) 3 percent of qualifying i^al property loans.
Under the 60-percent method, a mutual institution is permitted to
deduct each year an amount equal to 60 percent of its taxable income
(computed before any bad-debt deduction). Under the 3-percent
68
method, an institution is permitted to deduct an amount sufficient to
bring the balance of the reserve for losses on qualifying real prop-
erty loans to 3 percent of such loans outstanding at the close of the
taxable year, plus an amount sufficient to bring the balance of the
reserve for losses on other loans to a "reasonable" amount.
A savings and loan association and a cooperative bank are entitled
to use these special reserve methods only if they meet a comprehensive
set of investment standards, which were established by Congress in
the 1962 act to insure that the tax benefits are available only to those
institution primarily engaged in the business of home mortgage financ-
ing. Mutual savings banks, however, aro not subject to any investment
standards under these tax provisions and may use the special reserve
methods regardless of the amount of their investments in home mort-
gage financing.
Problem. — In 1952 Congress repealed the exemption of these insti-
tutions from Federal income tax and subjected them to the regular
corporate income tax. At that time, however, these institutions were
allowed a special deduction for additions to bad-debt reserves which
proved to be so large that they remained virtually tax exempt. In the
Revenue Act of 1962, Congress sought to end this virtual tax exemption
by providing the special alternative methods for these institutions in
the computation of their bad-debt reserve. Although these methods
are more restrictive than prior law, they still provide highly favorable
treatment for the bad-debt reserves of these institutions.
It was expected that most of these institutions would compute their
deduction under the 60-percent method, which requires the payment
of some tax, while the 3-percent method would be an alternative
primarily benefitting a limited number of new or rapidly growing
institutions. In practice, about 90 percent of the savings and loan
associations use the 60-percent method, but most mutual savings banks
use the 3-percent method and as a result have been able to avoid
substantially all Federal income taxes.
House solution. — The bill revises the treatment of mutual savings
banks and savings and loan associations in a number of ways. It
amends the special bad-debt reserve provisions by eliminating the 3
percent method and reducing the present 60 percent method to 30
percent gradually over a 10-year period.
The bill also revises the present investment standard applicable to
savings and loan associations by liberalizing the composition of the
qualifying assets and by applying the standard to mutual savings
banks, as well as the other mutual nistitutions, as the basis on which
the percentage for the special deduction method is determined. This
new investment standard is a flexible one which reduces the percent-
age (applied against taxable income to compute the bad debt reserve
deduction) depending on the percentage of the assets invested in the
quahfymg assets — residential real property loans, liquid reserves, and
certam other assets. The full percentage (presently 60, to become 30)
is to be allowed generally only if the institution has a prescribed
percentage (82 percent for savings and loan associations and 72 per-
cent for mutual savings banks) of its investments in qualifying assets
Ihe percentage is proi^ortionately reduced where an institution's qual-
ifying assets are less than the prescribed percentage of total aiets,
but if less than 60 percent of its funds are in qualifying assets the
69
percentage deduction method may not be used. The bill also allows
these institutions to compute additions to their bad debt reserves on
the basis of the 6-year moving average of their own experience (which
is the new method provided by the bill for commercial banks), rather
than on the basis of the percentage deduction method.
The bill also extends the net operating loss carryback for these
institutions from 3 to 10 years, which allows the spreading of losses
over 15 years (10 years back and 5 years forward), and provides for
the same treatment of new institutions as is provided for new com-
mercial banks. Generally, this provision applies to years beginning
after July 11, 1969, although various transitional rules also are
provided.
Arguments For. — (1) Since the House bill increased appreciably the
effective rate of tax for commercial banks, a somewhat comparable in-
crease in the effective tax rate for these institutions also is necessary.
This is accomplished by (a) the repeal of the 3-percent method which
has allowed mutual savings banks to remain virtually tax-free, and
(b) the percentage reduction in the formula (from 60 to 30) . Although
raising the effective rate of tax, these changes will still leave a signifi-
cant margin of tax advantage for them over commercial banks, pre-
serving the inducement for them to continue investing in real estate
mortgages.
(2) This and the other changes provide an assurance that signifi-
cant tax will be paid in most cases on the retained earnings of these
institutions, while at the same time providing reserves consistent with
the proper protection of the institution and its policyholders in the
light of the peculiar risks of long-term lending on residential real
estate which is the principal function of these institutions.
(3) Although savings and loan associations are required (as a con-
dition to favored tax deductions) to invest large amounts of their
deposits in home-oriented mortgages, mutual savings banks are not
similarly controlled as to their investments. By subjecting mutual sav-
ings banks to an investment standard (even one more generous than
that applicable to savings and loan associations) the bill restricts
preferential tax treatment to those instances where some preference
still appears warranted.
(4) By extending the carryback for net operating losses from 3 to
10 years (allowing 15 years for such losses), the bill adequately pro-
vides for large unexpected losses.
Argu7nents Against. — (1) Congress recognized in 1962 the 60 per-
cent deduction rule offered insufficient protection to member- depositors
of rapidly growing mutual thrift institutions and so it provided the
3 percent rule as an appropriate alternative. The bill reverses this
conscious Congressional decision.
(2) Mutual savings banks do not possess the same home mortgage
background as savings and loan associations and prior Congresses
have wisely left their investment practices disassociated from heavy
involvement in home mortgages.
(3) The unique nature of real estate mortgages (very long term)
makes it difficult to liquidate them in times of financial stress and this
justifies the present loss reserve rules applicable with respect to these
investments.
70
(4) These changes will adversely affect home mortgage financing,
contrary to the intent of Congress, because increased taxes will mean
less funds for loans, a lower return, and less protection for depositors.
This will further retard an industry already hard hit by high interest
rates.
(5) With the growth in the deposits of mutual savings banks, they
need additional reserves to provide necessary protection for their
depositors.
(6) The more generous investment standard will lead to heavier in-
volvement in fewer properties, thereby exposing depositors to greater
risks.
3. Treatment of Bonds Held by Financial Institutions
Present law. — Commercial banks and mutual savings institutions
receive special tax treatment in regard to their transactions in bonds
and other corporate and governmental evidences of indebtedness. Like
other taxpayers, they can treat long-term gains from such transactions
as long-term capital gains for tax purposes. However, unlike other
taxpayers, they can treat capital losses from such transactions as or-
dinary losses and may deduct such losses without limit from ordinary
income.
Problem,. — The present nonparallel treatment of gains and losses on
bond transactions by financial institutions appears to have inequitable
results.
Transactions of financial institutions in corporate and government
bonds and other evidences of indebtedness do not appear to be true
capital transactions ; they are more akin to transactions in inventory
or stock in view of the size of the bank holdings of these items and the
extent of their transactions in them. Moreover, financial institutions
now maximize their tax advantages by arranging their transactions
in bonds in the light of existing market conditions in order to realize
gains in selected years and losses in other years. This enables them to
report their gains as capital gains for tax purposes and their losses as
ordinary losses chargeable against regular income. The result is to per-
mit financial institutions to reduce their taxable liability and to receive
preferential treatment over other taxpayers.
House solution. — The House bill provides parallel treatment for
gains and losses derived by financial institutions on transactions in
corporate and governmental bonds and other evidences of indebted-
ness. Under the bill, financial institutions are to treat net gains from
these transactions as ordinary income instead of as capital gains but
they will continue to treat net losses from such transactions as ordi-
nary losses as under present law. This provision applies to taxable
years beginning after July 11, 1969.
Arguments For. — (1) This provision removes the preferential treat-
ment accorded to financial institutions over other taxpayers in regard
to transactions in corporate and government bonds. It would have
been possible to treat financial institutions exactly like other taxpaj^ers
with regard to such transactions — ^that is, treat the gains as capital
gains and the losses as capital losses. However, it is understood that
the financial institutions prefeiTed the ordinary income tax treatment
provided by the House bill to consistent capital gains treatment for
their bond gains and losses, because they want to continue to have the
protection offered by ordinary loss treatment on their bond losses.
71
(2) The bill prevents banks from so arranging their affairs as to
realize gains from their securities when they have no other mcome,
and to preserve losses on these securities until years in which they are
profitable.
Arguments Against.— {1) The bill will further depress an already
weak securities market by discouraging banks from buymg and sellmg
securities and this will have an adverse impact on Treasury revenues.
(2) The existing law reflects a wise policy of treating losses realized
by financial institutions on governmental and corporate securities as
ordinary losses while encouraging banks to invest in such securities
(and thus create a market for government bonds) by offering capital
gains treatment on potential profits; changing the existing law can
only serve to narrow the market for governmental securities, making
Federal debt management more difficult.
4. Foreign Deposits in U.S. Banks
Present Zaw.— Present law provides special rules, for purposes of
the income tax and the estate tax, for the treatment of U.S. bank
deposits, and the interest thereon, of foreign persons.
In general the effect of these special rules is to exempt this type of
interest income received by foreign persons from U.S. tax and to
exempt the deposits from the estate tax. Under present law the special
bank deposit rules are to cease to apply at the end of 1972. In other
words, after 1972 the interest on these bank deposits otherwise would
be subject to income tax and the bank deposits themselves would be
subject to the estate tax.
Prohlem.— Congress provided, in 1966, that the special treatment
accorded U.S. bank deposits of foreign persons should be terminated.
It was believed, however, that an immediate elimination of the special
rules might have a substantial adverse effect on the balance of pay-
ments. Accordingly, it was decided to postpone the elimination of the
special rules until i he end of 1972. In view of the continuing deficit in
the balance of payments, it appears that our balance of payments situa-
tion might be adversey affected to a substantial degree if the special
treatment were removed at the end of 1972.
House solution. — The bill provides that the special income tax and
estate tax rules regarding U.S. bank deposits (including deposits with
savings and loan associations and certain amounts held by insurance
companies) of foreign persons are to continue to apply until the end
of 1975.
Arguments For. — (1) Postponement of the termination dat© for
the special bank deposits rule will forestall the possibility of an out-
flow of funds from the United States (in anticipation of the termina-
tion of the special status) and the resulting harmful effect on our
balance of payments.
(2) The bill retains the long-term goal set by Congress in 1966 of
eventually treating foreigners who deposit their money in U.S. banks
in the same manner as U.S. citizens are treated with respect to their
bank deposits, both under the income tax and the estate tax.
(3) The bill recognizes the desirability of continuing the present
U.S. income tax exemption for interest paid on foreign-owned bank
deposits — and the estate tax exemption with respect to the deposits —
in order to encourage an inflow of foreign capital and thus help adjust
our unfavorable balance of payments.
72
Argimients Against. — (1) The tax reform bill is designed to elimi-
nate preferences in the tax law and make the tax burden more equal
on all persons who have U.S. income and property ; this feature of the
bill runs counter to the objectives of tax reform and tax equity by con-
tinuing a pronounced preference in the tax law beyond the date when
it would ordinarily end.
(2) Questions can be raised as to whether the termination of this
special treatment, in fact, will have an appreciable adverse effect on
the balance of payments. ^
R. DEPRECIATION ALLOWED REGULATED INDUSTRIES
1. Accelerated Depreciation
Present law. — Regulated industries may make the same elections as
other taxpayers regarding depreciation of their business property.
About half the regulatory agencies require utilities that use accelerated
depreciation to "flow through" the resulting reduction in Federal in-
come taxes currently to income. (Where the utility is earning the maxi-
mum allowed by law or regulations, this results in flowing through the
tax reduction to the utility's current customers.) Other agencies per-
mit the utilities they regulate to "normalize" the deferred tax liabilities
resulting from accelerated depreciation. (This involves the utillity
retaining the current tax reduction and using this money in lieu of
capital that would otherwise have to be obtained from equity invest-
ments or borrowing.) Some agencies insist that utilities subject to their
jurisdiction use accelerated depreciation for tax pui-poses and, in a
few rate cases, such agencies have treated the utilities they regulate as
though they used accelerated depreciation (and flowed through the
resulting tax reduction), even though the utilities may have in fact
used straight-line depreciation.
Prohlem. — The trends of recent years are shifts from straight line
to acclerated depreciation and shifts from normalization to flow-
through, often against the will of the taxpayer utilities. In general,
flow through to customers doubles the revenue loss involved in shifting
from straight-line to accelerated depreciation. It is understood that
continuation of these trends would shortly lead to revenue losses of
approximately $1.5 billion. Consideration of legislative action in this
area is complicated by the fact that many utilities do not have effective
monopolies while others do ; many utilities are in growing industries
while others are losing ground; many utilities compete (to the extent
they face any competition) only with other regulated utilities while
others compete with businesses not subject to governmental rate
regulation.
House solution. — The bill provides that, in general, utilities brought
under these provisions will be "frozen" as to their depreciation prac-
tices. As to existing property : if straight-line depreciation is presently
being taken, then no faster depreciation may be used ; if the taxpayer
is taking accelerated depreciation and is normalizing, then accelerated
depreciation can continue to be taken only if the taxpayer continues to
normalize; no change is required if the taxpayer is now on flow-
through. As to new property : a taxpayer presently on straight line or
presently on accelerated depreciation with normalization will be per-
73
mitted to take accelerated depreciation only if the tax benefits are nor-
malized in the manner described above (otherwise such taxpayers must
take only straight line depreciation) ; no change is made if the tax-
payer is now on flow-through insofar as the same kind of property is
involved. The bill also does not change the power of the agency, in the
case of normalization, to exclude the normalized tax reduction from
the base upon which the company's maximum permitted profits are
computed. These rules apply to property used predominantly in the
trade or business of the furnishing or sale of: electrical energy, water,
sewage disposal services, gas through a local distribution system, tele-
phone sei-vices (other than those provided by COMSAT), or trans-
portation of gas, oil (including shale oil), or petroleum products by
pipeline, if the rates are regulated by a utilities commission or similar
agency.
The changes apply to taxable years ending after July 22, 1969.
Argmnents For. — (1) The bill substantially forestalls the entire
revenue loss that continuation of existing trends would have made
almost inevitable. It does so in a way that (with very few exceptions)
will require no increase in utility rates because of the tax laws, since
by and large, it merely takes the various regulatory situations as it
finds them and freezes those situations.
(2) Although regulatory commissions have adopted widely varying
rules relating to the depreciation policies, this change will assure
uniform tax rules for all affected utilities in the future.
Argujnents Against. — (1) The change will deny to some utility tax-
payers the tax benefits of accelerated depreciation which are avail-
able to other taxpayers. The denial would be inconsistent and dis-
criminatory.
(2) The bill is discriminatory against rate-payers to the extent that
utilities under present law may adopt accelerated depreciation on their
investments and "flow-through" the tax deferral to these ratepayers.
(3) This change infringes upon the authority of the various Federal
and State commissions to regulate the accounts, financial reports, and
rates of the various utilities which they are charged to supervise.
(4) Regulated utilities should be limited to straight line depreciation
since they must expand services in accordance with their customers'
needs and are protected from competition.
(5) All utilities should be permitted to elect accelerated depreciation
with normalization, as a method for meeting competition oy means
that accord with generally preferred accounting standards.
2. Earnings and Profits
Present law. — A dividend is defined as a distribution of property
by a corporation to its shareholders out of earnings and profits. If a
distribution exceeds the corporation's earnings and profits, then the
excess is a "tax-free dividend" (not currently taxable to the share-
holder) which reduces his cost basis in the stock (increasing capital
gain or reducing capital loss if the stock is sold by him) . Earnings and
profits in general are computed by reference to the method of depreci-
ation used in computing the corporation's taxable income and so are
reduced by the amount of depreciation deducted by the corporation
on its return.
74
Problem. — Tax-free dividends (in effect, resulting in current avoid-
ance of tax at ordinary income rates in exchange for possible post-
poned tax at long-term capital gains rates) appear to be increasing in
a number of industries. Especially among utilities, a number of com-
panies are regularly making such distributions. It was indicated that
in 1968 private power companies alone made such tax-free distribu-
tions totaling approximately $260 million. Statistical information is
not readily available in the real estate industry on this point, but
it is understood that substantial amounts of corporate distributions
in this industiy are also tax-free. Availability of these tax benefits
is generally unrelated to the purposes of accelerated depreciation and
is of greatest value to individuals in high tax brackets.
House solution. — The bill provides that, for the purpose of comput-
ing its earnings and profits, a corporation is to deduct depreciation
on the straight line method, or on a similar method providing for
ratable deductions of depreciation over the useful life of the asset.
This provision would not affect the amount of depreciation that can
be deducted in determining the corporation's Federal income tax.
This provision applies to earnings and profits for taxable years
beginning after June 30, 1972.
Arguments For. — ( 1 ) This provision is supported on the ground that
it is expected to put an end to the increasing practice of distributing
tax-free dividends. It will not affect the corporations' tax liabilities
but can affect the tax liabilities of the shareholders. It should end the
use of this unintended substantial benefit to high-bracket taxpayers,
which use is generally unrelated to the purposes for which accelerated
depreciation deductions are made available to corporations.
(2) This rule regarding depreciation is essentially the same as what
is currently required in the case of percentage depletion (where cost
depletion is used for earnings and profits computations) .
Arguments Against. — (1) The ability to distribute "tax-free divi-
dends" is part of the structure of many corporations, and change in
this regard will result in substantial reduction in the market price of
those corporations' shares. It is noted, in reply, that three years are
provided for market adjustments before the change takes effect.
(2) Accelerated depreciation is unlike prcentage depletion in that
it merely allocates the same amount of deductions over a different
period of time — consequently, the earnings and profits treatment of
percentage depletion should not be used as a model for the treatment of
accelerated depreciation.
(3) Earnings and profits, for purposes of determining dividend
distributions, should be computed by the same accounting rules used
in determining income tax of the corporation. Eventually the amount
of earnings and profit of a corporation from a particular investment
should be the same whether the method of depreciation is an accel-
erated method or the straight-line method. The increase in the accu-
mulated earning and profits in the latter years of the corporation
should make up for the decreased earnings from the property in the
earlier years.
75
S. ALTERNATIVE CAPITAL GAIN RATE FOR
CORPORATIONS '
Present law. — Corporations that have an excess of net long-term
capital gains over net short-term capital losses may use the "alterna-
tive tax," which taxes the entire excess net long-term capital gain at
25 percent. Since the corix)rate tax stiiictiire is not graduated (as in
the case for individuals) but is computed on the basis of a normal tax
of 22 percent of taxable income and a surtax of 26 percent of that part
of the taxable income which exceeds $25,000, usually only those corpo-
rations with taxable incomes in excess of $25,000 (on which the tax
rate would be 48 percent, ajDart from the effect of the surcharge) use the
alternative tax.
Problem. — The House bill eliminates the alternative tax for indi-
viduals, thereby raising their maximum capital gain rates. Accord-
ingly, it appears appropriate to raise the corporate alternative tax rate
to a greater percentage of the regular corporate tax rate. In addition,
since corporations are not subject to graduted tax rates they usually
do not encounter the problems, of having bunched income, which has
accrued over more than a one year period, taxed in one year at steeply
graduated rates, which is one of the reasons for providnig special tax
treatment to capital gains.
House solution. — The bill increases the alternative tax rate which is
applied to a corporation's net long-term capital gains from 25 to 30
percent. This provision applies to sales and other dispositions after
July 31, 1969.
Arguments For. — (1) A corporation's capital gains, in comparison
with those of an individual, are more in the nature of business income
which is not essentially different from the corjaoration's other income.
(2) Because other changes in this bill provide that the alternative
tax for individuals will be raised, in effect, to a maximum rate of 35
percent (scaling down later to 32.5 percent) , a comparable adjustment
should be made in the corporate tax on capital gains.
Argmnents Against. — (1) This provision results in an economically
iindesirable redistribution of income from the corporate sector of the
economy where it might be used for investment, to the individual
sector where it might be used for consumption. This is so because
the increase in revenues from this charge is used to provide tax relief
to individuals.
(2) The 30 percent rate appears to be an arbitrary rate which was
not developed from a study of corporate statistics.
T. NATURAL RESOURCES
1. Percentage Depletion
Present law. — At present, percentage depletion is granted to a wide
range of minerals. The depletion rates are 271^ percent for oil and ^as
wells; 23 percent for sulfur, uranium, and an extended list of min-
erals; 15 percent for metal mines, rock asphalt, vermiculite, and cer-
tain types of clay; 10 percent for coal and a limited group of other
minerals ; 7i/^ percent for clay, shale, and slate used for specified pur-
poses; and 5 percent for such items as gravel, peat, and sand, and cer-
1 Witnesses did not testify to this change in the law during the Ways and Means Com-
mittee hearings.
33-158 O — 69 G
76
tain minerals from brine wells. In addition, a 15-percent rate applies
to a final category which contains an extended series of minerals and
also includes all other minerals unless sold for riprap, ballast road
material, rubble, concrete aggregates, or for similar purposes. Percent-
age depletion is not granted in the case of soil, sod, dirt, turf, water, or
mosses or minerals from sea water, the air, or similar inexhaustible
sources.
Percentage depletion generally applies to the specified items regard-
less of whether the pertinent property is located in the United States
or abroad. However, except for sulfur and uranium, the 23-percent
percentage depletion rate applies only to deposits in the United States,
and foreign deposits of the other minerals in this category are eligible
for percentage depletion at the 15 percent rate.
The percentage depletion allowance is limited to a maximum of 50
percent of the taxable income from the property, computed before any
allowance for depletion. In any case where depletion based upon cost
is higher than percentage depletion, the higher amount is allowed as
a deduction.
Problem,. — Percentage depletion was adopted in 1926 when the prior
allowances based on discoveiy value in the case of oil and gas proved
difficult to administer and produced varying results. At that time, it
was recognized that percentage depletion could permit taxpayers to
recover amounts in excess of their investment. However, this was
deemed justified on the ground it would have the beneficial effect of
stimulating exploration for and discovery of new reserves of vitally
needed oil and gas.
It has been charged that if percentage depletion rates are viewed as
a needed stimulant at the present time they are higher than is needed
to achieve the desired beneficial effect on resei-ves.
The application of percentage depletion allowances to income from
oil and gas wells located in foreign countries has also been subject to
criticism. It is charged that insofar as percentage depletion is intended
primarily to encourage the exploration and discovery of new domestic
wells, the granting of percentage depletion to income from foreign de-
posits results in a loss of revenue without commensurate advantages.
Houfip solution. — The House bill affects percentage depletion in two
ways. First, the various percentage depletion rates are reduced as
follows :
[In percent]
Rate provided
Present rate by bill
Oil and gas wells (domestic)
Sulfur and uranium, and specified minerals from domestic deposits
Gold, silver, oil shale, copper and iron ore from domestic deposits
Remaining minerals now/ at 15 percent
Asbestos, coal, sodium chloride, etc _
Clay, shale and slate for specified uses
Gravel, sand, and other minerals now at 5 percent
As can be seen from this table, the bill provides for substantial reduc-
tions in percentage depletion rates for most ilems. However, some
27J^
20
23
17
15
15
15
11
10
7
VA
5
5
4
77
items — namely, gold, silver, oil shale, copper and iron ore — are to
remain at the present 15 percent rate in the case of deposits in the
United States.
Second, the bill provides that percentage depletion is not to be al-
lowed for foreign oil and gas wells. These changes in percentage de-
pletion allowances are effective for taxable years oeginnine: after July
22, 1969. J ^ ^
Argwnents For. — (1) The appropriate level of percentage deple-
tion rates depends on a number of factors including the effect on
incentives to discover new reserves, equity considerations involving
the payment by each taxpayer of his fair share of taxes, and revenue
considerations. This provision is supported on the ground that the new
percentage depletion rates represent a better balance than now exists
between all these objectives.
(2) Percentage depletion is symbolic of a preference-prone tax
structure that discriminates against persons whose incomes are wholly
or principally from fully taxable wages and salaries. To leave it un-
changed would invite the breakdown of our voluntary, self-assessment
system of taxation.
(3) The oil companies today do not pay a fair share of the Federal
tax burden, largely because of percentage depletion.
(4) If stimulation of discovery and development of oil deposits to
make the United States self-sufficient and independent of questionable
supplies of foreign oil is a goal of percentage depletion, then the bill
enhances that goal by doing away with percentage depletion on foreign
oil.
Arguments Against. — (1) Oil and gas producers now pay heavy
severance taxes to the States so that some measure of relief under the
Federal income tax is appropriate.
(2) Receipts from withdrawals of oil, gas and mineral reserves are
akin to receipts from the sale of a capital asset and should be given
relief just as capital gains are given relief by being taxed at a special
rate.
(3) Removal of percentage depletion from foreign oil and gas
wells will not produce any significant additional revenue for the
United States. This is because the foreign countries in which the
wells are located will raise their taxes until the foreign tax credits
allowed against U.S. tax absorb the increase in the U.S. tax resulting
from the removal of percentage depletion.
(4) It is not percentage depletion rates in general that raise the
charge of preferential treatment; rather, it is the specific 271^ percent
rate applicable to oil and gas. By cutting the rates applicable to vir-
tually all minerals the House bill unfairly portrays the entire mineral
industry as the beneficiary of undeserved tax largess.
(5) Doing away with percentage depletion on foreign oil ignores
the role the United States oil companies play in funnelling foreign
oil earnings back to this country to benefit our suffering balance of
payments. Similarly, it ignores the significance of expanding U.S.
influence over oil reserves and keeping them available for the free
world and out of Communist domination.
78
(6) Proved oil reserves today are declining; at a rapid rate in this
country, and there is insufficient new exploration. What the industry
needs is more, not less, stimulation to seek new deposits.
(7) The true measure of an industry's profitability and tax burden
is determined by reference to its gross income, not its net income,
which is how most critics of the oil industry analyze it. Viewed in
relation to its gross income the oil industry is less profitable, and more
heavily taxed, than the average of other industries.
2. Mineral Production Payments
Present law. — A mineral production payment is a right to a specified
share of the production from a mineral property (or a sum of money
in place of the production) when that production occurs. Depending
on how a production payment is created, it may be classified as a
carved-out production payment, or retained production payment
which may then be used in a so-called A-B-C transaction.
A carved-out production payment is created when the owner of a
mineral property sells — or carves out^ — a portion of his future produc-
tion. A carved-out production payment is usually sold for cash and,
quite often, to a financial institution. Under present law, the amount
received by the seller of the carved-out production payment generally
is considered ordinary income subject to depletion in the year in
which received. The purchaser of the production payment treats the
payments received as income subject to the allowance for depletion
(almost always cost depletion) and thus generally pays no tax on those
amounts (except for that portion of the payments which is in the
nature of interest) . The amounts utilized to pay the production pay-
ment are excluded from income by the owner of the property during
the payout period, but the expenses attributable to producing the
income are deducted by him in the year they are incurred.
A retained production payment is created when the owner of a min-
eral interest sells the working interest, but reserves a production pay-
ment for himself. Under present law the ow^ner of the retained produc-
tion payment receives income for which percentage depletion may be
taken during the payout period, or period during which he receives a
part of the production (or a payment based on production) . The pur-
chaser of the working interest excludes the amounts used to satisfy the
production payment during the payout period, but (until recently)
deducted the cost of producing the minerals subject to the production
payment.
The so-called A-B-C transaction is the same as a retained produc-
tion payment case, except that after selling the working interest, the
initial owner then sells the "retained production payment." Thus, in an
A-B-C transaction, the owner of the mineral property. A, sells it to
a second person, B, and reserves a production payment (bearina: in-
terest) for a major portion of the purchase price. He then sells the
production payment to a third party, C, which is usually a financial
institution, or, perhaps, a tax-exempt organization.
Problem. — It is charged that the use of carved-out production pay-
ments constitutes a problem because they are being employed to cir-
cumvent the limitations on the depletion deduction and the foreign tax
credit and to distort the benefits that the net operating loss provisions
were designed to provide. In addition, it is charged that in ABC
79
transactions, taxpayers are able to pay off what is essentially a pur-
chase money mortgage with before-tax dollars rather than after-tax
dollars.
House solution. — The bill provides in general that carved-out pay-
ments and retained payments (including ABC transactions) are to
be treated as a loan by the owner of the production payment to the
owner of the mineral property.
In the case of a carved-out production payment, the bill provides
the payment is to be treated as a mortgage loan on the mineral property
(rather than as an economic interest in the property). Thus, the pro-
ceeds received by the seller upon a sale of a production payment would
not be taxable to him. However, as income is derived from tlie property
subject to the carve out, that income would be taxable to the owner of
the property, subject to the depletion allowance. The cost of producing
minerals used to satisfy carved-out production payments would be
deductible when incurred.
This treatment is not to apply to a production payment carved out
for exploration or development of a mineral property if, under exist-
ing law, gross income is not realized by the person creating the
production payment.
In the case of retained production payments (that is, the sale of
mineral property subject to a production payment), the bill provides
that the production payment is to be treated as a purchase money
mortgage loan (rather than as an economic interest in the mineral
property). Accordingly, the income derived from the property which
is used to satisfy the payment would be taxable to the owner of the
mineral property subject, of course, to the allowance for depletion.
In addition, the production costs attributable to producing the min-
erals used to satisfy the production payment would be deductible by
the owner of the working interest in the year incurred.
Generally this provision applies to production payments created
after April 21, 1969.
Arguments For. — (1) In each of the three situations (the carved-
out production payment, the retained production payment, and the
ABC transaction, the transaction is similar in fact, to a loan trans-
action with the loan secured by a mortgage on the property and the
"borrower" not personally liable for the loan.
(2) The use of production payments produce tax benefits that are
in excess of the advantages Congress intended, in the case of the
depletion deduction, the foreign tax credit, and the net operating loss
carryover.
(3) Production payments enable taxpayers to avoid the 50 percent
limitation on percentage depletion by accelerating the time when they
realize income from the mineral property without also moving up the
expenses related to the production of the minerals pledged to pay off
the production payment. The bill will prevent this avoidance of the
limitation.
Arguments Against. — (1) Mineral production pavment transac-
tions are not loans and to treat them as such distorts the generally ac-
cepted concepts of the terms "loan and mortgage." A production pay-
ment, it is argued, creates only a property right, and not a debtor-
creditor relationship or the rights of a mortgage.
(2) To change the tax treatment of production payments would
adversely affect the collateral securing existing loans and would fur-
ther restrict the ability of the independent producers to finance their
operations with the proceeds of new loans.
3. Mining Exploration Expenditures
Present law. — Present law allows a taxpayer to elect to deduct, with-
out dollar limitation, mining exploration expenditures (that is, ex-
ploration expenditures for any ore or mineral other than oil or gas)
which are made prior to the development stage of the mine. The avail-
ability of this deduction is limited to mines located in the United
States or on the outer continental shelf. When a mine reaches the
producing stage, the exploration expenditures previously deducted
are recaptured, generally by disallowing the depletion deduction with
respect to the mine.
A taxpayer who does not elect this unlimited mining exploration
expenditure deduction is allowed a limited deduction for exploration
expenditures (whether on domestic or foreign mines) without the re-
capture rules applying. The total deduction under this limited pro-
vision for all years may not exceed $400,000.
ProhleTYi. — The allowance of a current deduction for exploration
expenditures without applying the recapture rules in the case of ex-
penditures for which the limited deduction is available provides more
generous treatment than in the case of most mineral producers which
are under the unlimited deduction provision. No reason is seen for this
difference in treatment.
House solution. — The bill provides that the general recapture rules
of present law are to apply to mining exploration expenditures (made
after July 22, 1969) which are deducted under the limited provision
of present law. Thus, a deduction will continue to be allowed for for-
eign or oceanographic explorations under the limited provision, but
the general recapture rules will apply with respect to these
expenditures.
Arguments For. — (1) A current deduction for exploration expend-
itures and, in addition, depletion on the property when the producing
stage is reached should not be allowed on the same property.
(2) The bill continues the present privilege which taxpayers have
of deducting foreign (and oceanographic) exploration expenditures
subiect to the same limitations as at present.
(3) The present law lacks uniformity in the tax treatment of
exploration expenses in that mining companies which choose to deduct
these expenses in excess of $400,000 (and present law permits the tax-
payer to elect to deduct greater amounts) are subject to a recapture of
all their exploration expenses as the mine becomes profitable, while
those which choose to limit their exploration expense deduction to
$400,000 would not be subject to the recapture. The bill provides uni-
form rules in this area by applying the recapture to all exploration
expenses where the mines become profitable.
Argumfients Against. — (1) The bill ignores the basis on which the
existing law is predicated. Until 1966 exploration expense deductions
were limited to $400,000, but in that year Congress eliminated the
limit (on an optional basis) principally to benefit the large companies
and the special recapture rule was a quid "pro quo for the higher de-
81
duction. Extension of the recapture rule to all exploratilon expenses
now, in effect, makes small mining companies pay for the benefit ex-
tended to the large companies in 1966.
(2) Since some companies are willing to limit exploration expendi-
ture deductions to $400,000, they should not be subjected to the recap-
ture rules.
4. Treatment Processes in the Case of Oil Shale
Present law. — The depletion allowance for oil shale under present
law is applicable only to the value of the rock itself — which has little
if any value. Liquid oil from wells, on the other hand have considerable
value.
ProW-em. — The industry will never develop in its use of oil shale
until oil from shale receives more nearly the same percentage deple-
tion allowance as oil produced from a well.
House solution. — The bill extends the point at which percentage
depletion is computed in the case of oil shale to after extraction from
the ground, through crushing, loading into the retort, and retorting,
but not to hydrogenation, or any refining process or any other process
subsequent to retorting.
Argument For. — Oil from shale should receive similar treatment to
that given to oil produced from a well, that is on the value of liquid oil.
Argument Against. — ^Tliis provision will allow percentage deple-
tion to be taken on certain manufacturing processes performed in
reducing oil shale to oil. The cut-off point should be at the completion
of the mining from the ground.
U. CAPITAL GAINS AND LOSSES
1. Alternative Tax
Present law. — One-half of an individual's net long-term capital
gains are included in taxable income and, accordingly, are taxed at
regular tax rates. The alternative tax — a maximum of 25 percent on
net long-term capital gains — is applied when an individual's marginal
tax rate exceeds 50 percent. For married couples filing a joint return,
the alternative tax is applied when other taxable income is greater
than $52,000. For single persons, the alternative tax is appliea when
other taxable income exceeds $26,000.
Problem. — The incentive for many high income taxpayers to con-
vert their income into capital gain is greater than for taxpayers sub-
ject to lesser rates because to the extent they do so the alternative tax
rate for capital gains decreases their effective tax rate by more than
one-half. This effect is associated with the extent that the taxpayer's
income is greater than the level where the 50 percent marginal tax
rate is effective.
House solution. — The bill eliminates the alternative tax rate for net
long-term capital gains for individuals. The provision applies to sales
and other dispositions made after July 25, 1969.
Arguments For. — (1) It is appropriate to remove the alternative
capital gains rate to lessen the incentive for individuals to plan the
conversion or ordinary income into capital gains.
(2) The alternative tax on capital gains benefits only the super-
rich — those whose marginal income tax rate exceeds 50 percent — by
82
allowing them to, in effect, deduct more than 50 percent of their capital
gain. The bill properly corrects this situation by assuring the same
tax treatment for all capital gain income without regard to the indi-
vidual's tax bracket.
(3) The alternative tax rate is at variance with the intent of the
progressive rate structure which underlies our income tax laws. The
bill more closely reflects the goal of taxing individuals according to
their ability to pay.
(4) The alternative tax, because it is set at a maximum of 25 per-
cent, operates to create an excessively large difference between the tax
rate paid on capital gains and that paid on ordinary income by tax-
payers in higher tax brackets.
Arguments Against. — (1) More liberal capital gains treatment is
needed to spur the assumption of risk of enterprise and the responsi-
bilities of ownership. For this reason, the alternative tax rate should
be decreased rather than increased.
(2) An increase in the amount of the capital gain tax will reduce
capital transactions, thereby reducing revenues to the Treasury at
the very time other provisions of the bill are raising taxes.
(3) The effective tax rate for individuals with high taxable in-
comes may be increased by as much as 40 percent above present rates
(from 25 percent to 35 percent) .
2. Capital Losses of Individuals
Present law. — Under present law, both individual and corporate
taxpayers may deduct capital losses to the extent of their capital gains.
In addition, if an individual's capital losses exceed his capital gains,
he may deduct up to $1,000 of the excess loss against his ordinary
income. (On the other hand, where an individual has a net long-term
capital gain rather than a net capital loss, a maximum of only one-
half of the net long-term capital gain is subject to tax.)
When a husband and wife each have capital transactions and a joint
return is filed, their respective gains and losses are treated as though
they had been realized by only one taxpayer and are offset against
each other. On the other hand, when both spouses have capital losses
and file separate returns, each spouse is allowed to deduct up to $1,000
of net capital losses from ordinary income.
Prohlem. — ^The present treatment of long-term capital losses is in-
consistant in the case of individuals with the treatment of their long-
term capital gains. Although a maximum of fifty cents of each one
dollar of long-term capital gains is subject to ordinary tax, when
capital losses exceed capital gains, the excess loss is deductible dollar-
for-dollar against ordmary income (up to a maximum of $1,000).
In addition, when it is more advantageous to them, married couples
can file separate returns, be treated as two separate taxpayers, and be
allowed to deduct up to $1,000 of capital losses from ordinary income.
This treatment is permitted even though married couples are generally
treated as one taxpayer. This treatment of losses tends to provide an
advantage for people living in community property states because all
gains and losses from community property are attributable in equal
amounts to each of the spouses by operation of community property
law and, therefore, they are automatically eligible for the benefit of
the double deduction. On the other hand, spouses living in noncom-
83
munity property states must have separate losses in order to claim this
advantage — hence, they must either sell assets held in their joint
names or each must sell his own assets. (In addition, they must have
equal incomes or the loss offset may be more than offset by a difference
in tax as a result of this variation in income.)
HoiLse solution. — The House bill provides that only 50 percent of an
individual's long-term capital losses may be offset against his ordinary
income. (Short-term capital losses, however, would continue to be
fully deductible.) In addition, the deduction of capital losses against
ordinary income for married persons filing separate returns is limited
by the House bill to $500 for each spouse. These provisions apply to
years beginning after July 25, 1969.
Arguments For. — (1) Taxpayers who are able to manage their in-
vestments to realize their gains and losses in different years are able to
take advantage of the present disparity in treatment of gains and
losses. Thus, they are able to take the 50 percent deduction for net-
long-term capital gains in one year and to also take a full deduction
for long-term capital losses in another year.
(2) The present treatment of capital losses also results in a special
benefit to spouses who file separate returns to enable each to deduct
up to $1,000 of those losses from ordinary income. This advantage
is automatic for persons in community property states, whereas, spouses
living in non-community property states must either hold property
in joint tenacy or own separate property before they may obtain this
advantage. In addition, married persons in non-community property
states who file separate returns must be w-illing to forego the split-
income rates applicable to joint returns, w^hile couples in community
property states do not lose this advantage even though separate returns
are filed.
(3) Present law discriminates against taxpayers whose investments
are not readily marketable in favor of those taxpayers who can more
freely manipulate sales of their investments to maximum advantage.
Arguments Against. — (1) An individual with a capital loss has
suffered a loss in the full amount, and it is unfair to deny him the
full benefit of this loss.
(2) If only a portion of an individual's net capital loss can be
offset against his other income, the individual will be less willing to
incur the risk of investment in new ventures and the economy will
suffer.
(3) The bill fails to achieve consistency in treatment between capi-
tal gains and capital losses because while capital gains are taxed in
full, only $1000 of capital losses may be deducted from ordinary in-
come annually. This provision of the bill should be deferred until the
entire treatment of capital losses can be explored.
3. Collections of Letters, Memorandums, Etc.
Present law. — Present law excludes copyrights and literary, musi-
cal, or artistic compositions (or similar property) from the definition
of a capital asset, if they are held by the person whose efforts created
the property (or by a person who acquired the property as a gift from
the person who created it). Thus, gain arising from the sale of such
a book, artistic work, or similar property is treated as ordinary in-
come, rather than as capital gain. However, since collections of letters,
memorandums, etc. (including those prepared for the individual) are
84
not excluded from the definition of a capital asset, gains from the sale
of such property are accorded capital gains treatment.
Problem. — The rationale underlying the present law treatment of
artistic works and similar property in the hands of the person who
created them, in effect, is that the person is engaged in the business
of creating the artistic work or similar property. In view of this, the
gain arising from the sale of the property is treated as ordinary in-
come, rather than as a gain from the sale of a capital asset.
It is difficult to see wihy this treatment should not extend to collec-
tions of letters, memorandums, etc., created by the person or prepared
for or given to him. In the one case a person who writes a book and then
sells it is treated as receiving ordinary income on the sale of the product
of his personal efforts ; in the one case, one who sells a letter or memo-
randum written by, or for, him is treated as receiving capital gain on
the sale even though the product he is selling is, in effect, the result
of his personal efforts.
House solution. — The House bill excludes letters, memorandums,
and similar property from the definition of a capital asset, if they are
held by a person whose efforts created the property or for whom the
property was prepared or produced (or if received as a gift from such
a person). Thus, the gain on a sale of these letters or memorandums
would be treated as ordinary income, rather than as a capital gain.
This provision applies to sales and other dispositions after July 25,
1969.
Argumnent For. — Collections of papers and letters are essentially sim-
ilar to a literary or artistic composition which has been created by the
personal efforts of the taxpayer. Both types of w orks should be classi-
fied in a similar manner for purposes of income taxation. It is logical
to consider income from both these types of personal effort as income
arising from the sale of property in the "ordinary course of a trade
or business."
Arguments Against. — (1) Since other forms of earnings by an
individual in some cases result in capital gains there is no reason
for changing the treatment of such collections of letters, memoran-
dums, etc., held by the person who created them, or for whom they
were prepared or produced.
(2) If this kind of property is to be taxed it should be taxed as a
capital gain in recognition of the fact that their value is attributable
to work performed over a period longer than a single year.
4. Holding Period of Capital Assets
Present law. — ^^Oapital gains on assets held longer than 6 months
are considered long-term gains. In the case of individuals, 50 percent
of the excess of net long-term capital gains over net short-term
capital losses is included in income. In the case of corporations, the
excess is taxed at a maximum rate of 25 percent (30 percent under the
bill) rather than at the regular 48 percent corporate rate.
Problem,. — The distinction between the treatment of long and short
term gains is based on the belief that gains which accrue over long
85
periods of time should not be taxed as ordinary income and that special
treatment should be provided for investment, as opposed to speculative
^ains. The 6 -month holding period does not appear to be an adequate
implementation of either of these concepts. It affords special treatment
to gains which accrue over a period of less than a year and it does
not appear to adequately distinguish between speculative and invest-
ment gains.
House solution. — The House bill provides that a long-term capital
gain is to be a gain from the sale or exchange of a capital asset held
for more than 12 months. This provision applies to taxable years
beginning after July 25, 1969.
Argwiwnts For. — (1) Lengthening the holding period to one year
is necessary to restore the original concept of the capital gains tax —
that is, that these gains accruing over a period longer than one taxable
year should not be "bunched" together and subjected to the grad-
uated tax rates generally applicable to income normally received
on an annual basis.
(2) A person who holds an investment for little more than six
months is primarily interested in obtaining speculative gains from
short-term market fluctuations which may be taxed at favorable rates.
In contrast, the person who holds an investment for a long time prob-
ably is interested fundamentally in the income aspects of his invest-
ment, and in its long-term appreciation in value. The available
evidence su,ggests that assets held for a period between six months and
one year tend to be speculative. Further, a study made in 1962, of
gains from corporate stock transactions revealed that almost 90 per-
cent of all capital gains in that year arose from sales occurring after
one vear of possession. By fixing the holding period at one year the
bill reflects all these considerations.
Arguments Against. — (1) Lengthening the holding period would
cause investors in securities to postpone the sale of these securities.
This, in turn, would seriously reduce the liquidity of the various
securities markets and would reduce, as well, the Federal revenues
from capital gains.
(2) Many persons believe that any lengthening of the holding pe-
riod should be accompanied by a decrease in the maximum capital
gain rate which would apply to such a gain.
5. Total Distributions From Qualified Pension, Etc., Plans
Present law. — An employer who establishes a qualified employee
pension, profit-sharing, stock-bonus, or annuity plan is allowed to
deduct contributions to the trust, or if annuities are purchased, may
deduct the premiums. The employer contributions to, and the earn-
ings of, a tax-exempt trust generally are not taxed to the employee
until the amount credited to his account are distributed or "made
available" to him. Retirement benefits generally are taxed as ordinary
income under the annuity rules when the amounts are distributed,
to the extent they exceed the amounts contributed by the employee.
Thus, employee contributions to a j)ension, etc. fund are not taxed
8G
when received since these amounts were contributed from after-tax
dollars of the employee.
An exception to the general rule of ordinary income treatment of
pension benefits, however, provides that if an emplo;yee (except self-
employed persons) receives his total accrued benefits in a distribution
within 1 taxable year on account of separation from service or death,
the distribution is taxed as a capital gain, rather than ordinary income.
If part or all of this total distribution consists of employer securi-
ties, the employee is not taxed on the net mirealized appreciation in
the securities at the time of distribution but instead only when the
stock is subsequently sold by the employee. The employee is taxed only
on the portion of the employer securities attributable to the employer's
cost at the time of the contribution to the trust. Furthermore, this
portion is taxed at the long-term capital gains rate, rather than at
ordinary income rates.
Probtem. — The capital gains treatment of lump-sum pension dis-
tributions was originally enacted in the Revenue Act of 1942 as a
solution to the so-called bunched-income problem of receiving an
amount in 1 taxable year which had accrued over several years.
The capital gains treatment afforded lump-sum distributions from
qualified pension plans allows employees to receive substantial aipounts
of deferred compensation at a much more favorable tax rate than other
compensation received for services rendered. Moreover, it appears that
the more significant benefits accrue to taxpayers with adjusted gross
incomes in excess of $50,000, and that a number of lump-sum distribu-
tions of $800,000 to over $1,000,000 have been made.
House solution. — The bill limits the extent to which capital gains
treatment will be allowed for lump-sum distributions from qualified
employees' trusts made within 1 taxable year. Capital gains treat-
ment is to be limited to the amount of the total distribution in excess
of employer contributions made during plan years beginning after
1969. Thus, amounts attributable to employer contributions made
during plan years beginning after 1969 will be treated as ordinary in-
come. This applies also to the amount of employer contributions of
employer securities to the plan.
The bill also provides for a special 5-year "forward" averaging of
the amounts to be treated as ordmary income. The taxpayer computes
the increase in tax as a result of including 20 percent of the ordinary
income amount of the distribution in his gross income for the taxable
year in which the total distribution is made, and then multiplies the
mcrease in tax by 5 to obtain his tax liability on the ordinary income
portion. The bill further provides that the taxpayer may recompute
his tax on the ordinary income portion at the end of 5 years by adding
20 percent of the amount in the gross income in each of the 5 taxable
years, and if this method results in a lower tax than previously paid,
he is entitled to a refund.
Arguinent For. — It is appropriate to treat at least the amount
of the employer contributions to a pension trust (including contri-
butions of employer stock) as ordinary income, since at is deferred
compensation for services rendered over the period of employment
which otherwise would be taxed as ordinary income. The bunched-
income problem of treating this pM>rtion of the distribution as ordinary
87
income is alleviated by the special 5-year averaging provision of the
bill.
Arguments Against. — (1) Opponents to any limitation on capital
gains treatment of lump-sum pension distributions contend that the
entire amount should continue to be taxed at capital gains rates, as
they maintain that the fact that these amounts accrue over many years
qualifies the distribution for special tax treatment.
(2) In the case of employer securities, the tax treatment of retire-
ment plans involving these securities should be left unchanged be-
cause it is possible to consider an employee's participation in such a
plan as if he had purchased the securities himself. Any change will
be detrimental to the interests of the employees who have had the
expectation of receiving capital gains treatment when they retire.
(3) The House bill does not go far enough in solving a basic tax
inequity as a result of the tax advantage granted to lump-sum pension
distributions in comparison with ordinary income treatment of all
other pension distributions. There is other income in the lump-sum
distribution which should appropriately be taxed as ordinary income,
such as the dividends received on the trust accumulations.
(4) The present law properly taxes as a capital gain amounts
received in one taxable year which are attributable to many taxable
years.
6. Sales of Life Estates, Etc.
Present luio. — Under present law, when a life estate and remainder
interest in property are acquired by gift, by bequest, or through
inheritance, the basis of the property is divided between the life estate
and the remainder. The owner of the life interest is not permitted to
deduct any portion of his basis over the life of his interest and thereby
to reduce for tax purposes the amount of income he receives from
his interest. However, where the life tenant sells his right to receive
future income, his basis in the property may be used to reduce the
gain he receives on the sale. The purchaser of the life estate is allowed
to amortize his basis (his purchase price) and, therefore, is able to
offset it against the income he receives from it.
Problem. — This treatment of life estates has the effect of allowing
a large portion, and in some cases, almost all of the income from a
life estate or similar interest to avoid taxation in those situations where
the life tenant sells his interest. This is because the life tenant is not
taxed on his income to the extent of his basis and, in addition, the
purchaser of this interest is not taxed on most of the income from it
because he is allowed to reduce that income by amortization deductions
for the purchase price which he pays for the interest. In addition, in
some cases the seller's basis has exceeded the amount he received upon
its sale, and he has been permitted to take a deductible loss.
House solution. — The bill provides that the entire amount received
on the sale or other disposition of a life (or term-of-years) interest in
property, or an income interest in a trust (which was acquired by
gift, bequest, inheritance, or by a transfer in trust), is to be taxable,
rather than only the excess of the amount received over the seller's
basis for his interest. This provision applies to sales or other disposi-
tions after July 25, 1969.
88
The House bill, however, does not change present law where a life
interest is disposed of as part of a single transaction in which the
entire fee interest is transferred (e.g., where a life tenant and remain-
derman simultaneously join in a sale of the entire property interest)
to any person or persons. In such a case, the gain realized by the life
tenant is to be measured by the excess of the proceeds received on the
disposition over his adjusted basis in the property.
Argument For. — The present tax law has the effect of allowing a
large part, and in some cases almost all, of the income from a life
estate to avoid taxation in those situations where the life tenant sells
his interest. The life tenant is not taxed on the income he receives from
the sale because he will usually have a tax basis equal to, or almost
equal to, the sales price. This is regarded as particularly undesirable
by those who view such transactions as an anticipatory assignment
of income rather than as the sale of a property interest.
Argument Against. — A sale of ia property interest is involved
and therefore it is appropriate in measuring !the amount of gain to
reduce the proceeds by the amount of the life tenant's basis.
7. Certain Casualty Losses Under Section 1231
Present law. — Generally, under present law (sec. 1231(a) of the
code), if the gains on the disposition of certain types of property
exceed the losses on this same type of property, in effect, the excess
is treated as long-term capital gain. On the other hand, if the losses
exceed the gains, then the net loss is treated as an ordinary loss. The
types of property subject to this provision generally are depreciable
property and real estate used in a trade or business.
An exception to this general provision is provided for uninsured
losses resulting from casualty or theft in the case of property used in
a trade or business (or capital assets held for the production of
income) . These uninsured losses are deductible in full against ordinary
income rather than being required to be netted with other gains and
losses under section 1231.
Problem. — The exception to the general section 1231 rule has lead to
anomalous results. A business taxpayer with a casualty loss on two
similar business properties, one of which is insured and one of which
is not, is allowed to deduct the uninsured loss in full against ordinary
income and at the same time is allowed to treat the gain on the insured
property (the excess of the amount of insurance received over his
adjusted basis in the property) as a capital gain. In other words, the
gain and loss do not have to be netted under section 1231. On the
other hand, the netting is required where the business taxpayer only
partially (perhaps 5 percent) insures a business property.
House solution. — The bill modifies the treatment of casualty losses
and casualty gains under section 1231. Casualty (or theft) losses on
depreciable property and real estate used in a trade or business and
on capital assets held for the production of income are to be consoli-
dated with casualty (or theft) gains on this type of property. If the
casualty losses exceed the casualty gains, the net loss, in effect, will be
treated as an ordinary loss (without regard to section 1231). On the
other hand, if the casualty gains exceed the casualty losses, then the
net gain will be treated as a section 1231 gain which must then be
consolidated with other gains and losses under section 1231. This rule
89
is to apply where the casualty property is uninsured, partially insured,
or totally insured. Although it was intended that casualty losses and
casualty gains on capital assets which are personal assets, such as a
personal residence or a nonbusiness automobile, were to be subject to
this special rule, they were not included through a drafting error.
The bill also clarifies the fact that uninsured casualty losses on per-
sonal assets are subject to the basic section 1231 provisions.
This provision applies to years beginning after July 25, 1969.
Argument For. — ^This provision eliminates the present unrealistic
distinction under section 1231 between insured and partially insured
casualty losses. In addition, it eliminates the possibility that a business
taxpayer can deduct an uninsured casualty loss on business property in
full from ordinary income, when he also has a larger casualty gain on
insured busmess property which would be treated as a capital gain.
Argument Against. — The bill fails to recognize the objective behind
the original adoption of present law in the Technical Amendments Act
of 1958 — that is, that taxpayers who self-insure their property should
be able to deduct their losses in full (without any type of reduction)
against ordinary income in the year of the loss in a manner similar to
taxpayers who insure their property with insurance companies, and
who are able to deduct their insurance premiums against ordinary
income (without any reduction) as they are paid.
8. Transfers of Franchises
Present law. — Questions have arisen under present law as to whether
the transfer of a franchise is to be treated as an outright sale or as a
mere license, and whether franchisors are selling franchises in the
ordinary course of business. Depending upon how these questions are
resolved, the franchisor will receive ordinary income or capital gains
treatment on the gain he realizes on the transfer of a franchise. At
present, these problems must be resolved under general tax principles,
and this has produced different results : i.e., capital gains in some situ-
ations and ordinary income treatment in others, despite factual simi-
larities in the interests in the franchises transferred.
Problem. — On several occasions the Tax Court has held that the
transfer of subf ranchises was not a sale for tax purposes and that all
gains therefrom were to be taxed as ordinary income. This position of
the Tax Court has been accepted generally by two Circuit Courts of
Appeals ; however, three other circuit courts have found sales to exist
in similar transactions and have allowed franchisors capital gains
treatment. Since present law does not specifically deal with the tax
treatment of the transfer of a franchise, and since this has resulted
in a considerable diversity of opinion among the courts as to whether
the transfer of a franchise constitutes a license or a sale (and whether
part or all of a sale of a franchise constitutes the sale of a capital asset)
there appears to be a need for legislation in this area.
House solution. — The House bill denies a franchisor capital gains
treatment on the transfer of a franchise if he retains any significant
power, right, or continuing interest with respect to the subject matter
of the franchise.
In the event the franchise agreement includes significant conditions
or restrictions which are subject to the franchisor's approval on a con-
tinuing basis, this power to exercise continuing, active, operational
90
control over the subfranchise will constitute the franchisor's retention
of a significant power, right, or continuing interest. Moreover, if the
franchisor's conduct constitutes participation in the commercial or
economic activities of the subfranchise then this conduct will be re-
garded as a retention of a significant power, right, or continuing in-
terest. The rule provided by tne bill, however, does not apply with re-
spect to amounts received or accrued in connection with a transfer of a
franchise which is attributable to the transfer of all substantial rights
to a patent, trademark, or trade name, to the extent the amounts are
separately identified and are reasonable in amount. These rules will
apply to transfers made after July 25, 1969.
Argwnent For. — The substantial growth of franchising throughout
the United States in recent years, and the split of authority among
the courts with respect to the proper tax treatment to be accorded
the transfer of a franchise, necessitates the adoption of more definite
guidelines in this area so that where a franchisor does not part with
all his interest in a franchise then the transfer will not be entitled to
capital gains treatment.
Argument Against. — On the other hand, it is argued that most
transfers of franchises are more like sales than licenses and, accord-
ingly should continue to receive capital gains trefatment.
V. REAL ESTATE DEPRECIATION
Present laio. — Under present law, the first owner may take deprecia-
tion allowances for real property under the double declining balance
method or the sum-of-the-years-digits method. These rapid deprecia-
tion methods generally permit large portions of an asset's total basis
to be deducted in the early years of the asset's useful life. A subsequent
owner is permitted to use the 150 percent declining balance method
which also provides more rapid depreciation than straight line in the
early years.
Depreciation is allowed on the total cost basis of the property (minus
a reasonable salvage value), even though the property was acquired
with little equity and a large mortgage.
Net gains on sales of real property used in a trade or business are,
with certain exceptions, taxed as capital gains and losses are treated
as ordinary losses. Gain on the sale of buildings is taxed as ordinary
income to the extent of depreciation taken on that property after De-
cember 31, 1963, if the property has been held not more than 12 months.
If the property has been held over 12 months, only the excess over
straight-line depreciation is "recaptured" and even that amount is
reduced after 20 months, at the rate of 1 percent per month, until 120
months, after which nothing is recaptured.
Problem. — ^The present tax treatment of real estate has been used by
some high income individuals as a tax shelter to escape payment of tax
on substantial portions of their economic income. The rapid deprecia-
tion methods now allowed make it possible for taxpayers to deduct
amounts in excess of those required to service the mortgage during the
early life of the property. Moreover, because accelerated depreciation
usually produces a deduction in excess of the actual decline in the
usefulness of property, economically profitable real estate operations
are normally converted into substantial tax losses, sheltering from
91
income tax such economic profits and permitting avoidance of income
tax on the owner's other ordinary income, such as salary and dividends.
Later the property can be sold and the excess of the sale price over the
remaining basis can be treated as a capital gain to the extent that the
recapture provisions do not apply. By holding the property for 10 years
before sale, moreover, the taxpayer can arrange to have all the gam
resulting from excess depreciation (which was offset against ordinary
income) taxed as a capital gain without the recapture provisions
coming into play. The tax advantages from such operations increase as
a taxpayer's income moves into the higher tax brackets. • • j •
Because of the present tax situation, when investment is solicited in
a real estate venture it has become the practice to promise a prospective
investor substantial tax losses which can be used to diminish the tax
on his income from other sources. Thus, there is, in effect, substantial
dealing in "tax losses" produced by depreciable real property.
Home solution.— The House bill revises real estate depreciation
allowances to limit the opportunities to use the present treatment
as a tax shelter and yet, at the same time, to maintain tax incentives
to build low income housing where the need is great.
Under the bill the most accelerated methods of real estate deprecia-
tion (the 200 percent declining balance and the sum-of-the-years-digits
methods) are limited to new residential housing. To qualify for such
accelerated depreciation at least 80 percent of the income from the
building must be derived from rentals of residential units. Other new
real estate, including commercial and industrial buildings, is to be
limited to the 150 percent declining balance depreciation method. In
general the new rules will not apply to property if its construction
began before July 25, 1969, or if there was a written binding contract to
construct the building before July 25, 1969.
Only straight line depreciation is to be allowed for used buildings
acquired after July 25, 1969. A special 5-year amortization deduction
is provided in the case of expenditures after July 24, 1969, however,
for the rehabilitation of buildings for low-cost rental housing.
Finally, the bill provides for the recapture of the excess of acceler-
ated depreciation over straight line depreciation on the disposition
after Jul}'^ 24, 1969, of depreciable real property (but only to the extent
of depreciation taken after that date). Thus, to the extent of this
excess depreciation, the gain on the sale of the real property will be
treated as ordinary income rather than as capital gain.
Arguments For. — (1) This provision strikes a good balance
between the need to curtail the availability of the real estate pro-
visions as a tax shelter and the need to provide adequate incentives
for the building of low income housing. Since the provision allows
the most accelerated methods of real estate depreciation to be used
for new residential housing, it continues the encouragement to build
the residential housing needed to meet present housing shortages. On
the other hand, by limiting new real estate other than residential
housing to the 150-percent declining balance method, by limiting used
buildings to straight line depreciation, and by strengthening the re-
capture provisions, the bill reduces the potential base of real estate as
a tax shelter.
(2) Many economically profitable real estate operations produce
substantial "tax losses" because of accelerated depreciation deductions
33-158 O— 69 7
92
which are used to avoid income tax on the taxpayer's other income,
such as salary and dividends, and in many cases result in the conver-
sion of ordinary income into capital gain.
(3) Reducing depreciation deductions for slum and ghetto housing
while continuing accelerated depreciation for new housing will make
investments in slum housing less attractive and lead to its earlier
demolition and replacement with modern housing, thus achieving a
socially desirable goal.
(4) Recapturing real estate depreciation taken in excess of straight
line depreciation at ordinary income tax rates not only simplifies
this area of the tax law, but also it more closely recognizes that the
larger deductions taken for depreciation reduced ordinary income
(even though the property itself actually did not decrease in value)
and should not now be allowed as a capital gain.
Arguments Against. — (1) There should be no change in the present
tax treatment of real estate because of the pressing need to encourage
the constiniction of more housing to eliminate the present housing
shortages. Tliis situation tends to imply that tax incentives have been
deficient rather than excessive.
(2) Accelerated depreciation is a particularly appropriate incentive
to real estate development in that it provides greater capital recovery
during the uncertain earlier years when real property has to prove
itself as a good or bad investment.
(3) The present recapture rules were carefully tailored to the pecu-
liar requirements of the real estate industry and no case of favoritism
has been established.
W. COOPERATIVES ^
Present Jatu. — In determining taxable income under present law,
cooperatives are permitted a deduction (or exclusion) for patronage
dividends paid in money or in qualified patronage allocations. They
also are permitted a deduction (or exclusion) for qualified per-unit
retain certificates (that is, certificates issued to patrons to reflect the
retention by the cooperative of a portion of the proceeds of the market-
ing of products for the patrons) .
A patronage allocation, or per-unit retain certificate, is qualified —
and therefore not taken into account by the cooperative — only if the
patron consents to take it into account currently as income (or as a
reduction in price in the case of purchases from the cooperative).
Thus, in general, a cooperative is not taxed on patronage allocations
or per-unit retains only if they are taxable to patrons. In the case of
qualified patronage dividends, present law requires that 20 percent
must be paid in money so that the patron will have all or part of the
money to pay the tax.
Prohleyn. — Qualified patronage allocations and qualified per-unit
retains may be considered as amounts distributed by the cooperative
to its patrons and reinvested in the cooperative as capital. However,
the patron often does not have an independent choice between invest-
ing them in the cooperative or retaining them for his own use. This
1 Witnesses did not testify to this change in the law during the Ways and Means
Committee hearings.
93
choice is frequently made by the members as a group, and it may
govern the use of a patron's funds even though he is not a member,
or became a member after the cooperative's practices in this regard
were established. Nevertheless, he is taxed as though he had full do-
minion over the entire j^atronage allocation or per-unit retain. More-
over, although most cooperatives revolve out these funds — on which
the patron has already paid the tax — within 4 to 15 years, some co-
operatives retain them indefinitely.
House solution. — Under the bill cooperatives are to be required to
revolve out patronage dividends and per-unit retains within 15 years
from the time the written notice of allocation is made or the per-unit
retain certificate is issued. In addition, the percentage of patronage
allocations which must be paid out currently in cash, or by qualified
check, is increased from 20 percent to 50 percent. The additional 30
percent may be paid with respect to the current allocation or in
redemption of prior allocations. The increase in the required payout
is phased in ratably over a 10-year period. These provisions apply to
taxable years beginning after 1969.
Arguments For. — (1) By requiring the cooperative to pay to the
patron all of the patronage dividends or per-unit retains within 15
years, the bill assures the patron that he will eventually receive the
patronage income on which he has been taxed. It is often argued, in
fact, that the patron should receive this money earlier.
(2) Farmers today have little dominion over the treatment of pa-
tronage dividends despite the fact that they must pay tax on them
as if they did. The bill will give them full control over one-half of the
patronage dividend immediately with assurances that the remaining
one-half (retained by the cooperative) will be paid out to them in 15
years. This greater control over the income^on which they are taxed
m^kes the tax more equitable.
(3) By requiring cooperatives to pay out more of their income cur-
rently the amounts they can retain tax-free for expansion of facilities
in competition withi fully tax'paying businesses is lessened. This is a
desirable way of limiting the tax-free growth of business enterprises.
Arguments Against. — (1) The House bill fails to recognize the sig-
nificance of the present rules whereby the patron in effect is given an
option to accept the patronage dividend and pay a tax on it. Those
rules were carefully devised to assure a single tax would always be
collected on the earnings of cooperative enterprises and the bill does
nothing to improve on present law in this respect.
(2) The bill ignores the role farm cooperatives play in improving
the incomes of farmers by providing them with alternative methods
of marketing their crops or of acquiring farm equipment, machinery
and suT)plies at reasonable prices.
(3) There is no showing that the present balance between farm co-
operatives and regular businesses should be upset to the detriment of
the cooi:>erative movement.
C4'i The renu irements for an early payout of patronage dividends
and retains ^vill impair the working capital of the cooperative, since
these amounts represent, in effect, the cooperative's equity capital and
serve as a base to support its borrowings.
94
X. SUBCHAPTER S CORPORATIONS
Present law. — ^Subchapter S of the Internal Revenue Code was
enacted in 1958 to provide tax relief for small business corporations
(those with 10 or fewer shareholders) by allowing them to elect not
to be taxed as a corporation, but instead to have the income or loss of
the corporation taxed directly to the shareholders in a pattern roughly
similar to that of partnership taxation. These provisions do not deal
with employee retirement plans; consequently, subchapter S corpora-
tions may establish corporate retirement plans for the benefit of share-
holders who are also employees of the corporation.
Prior to 1962, self-employed persons (proprietors and partners)
were not able to establish such plans to benefit themselves. In 1962,
however, Congress enacted the Self-Employed Individuals Retirement
Act (H.R. 10), permitting self-employed persons to be treated as em-
ployees of the businesses they conduct so that they may be covered
under qualified employees retirement plans in much the same manner
as their employees. These provisions, though, contain certain specific
requirements as to proprietors and partners which limit contributions
to 10 percent of the proprietor's or partner's earned income, or $2,500,
whichever is less.
Problem, — The H.R. 10 limitations on retirement income plans de-
scribed above (do not apply to corporations and so may be avoided
by a proprietor or the partners of a partnership by forming a corpora-
tion, electing subchapter S treatment, and then becoming employees of
the corporation. By the same token, a business that had incorporated
without contemplating a subchapter S election can avoid the burden
of the corporate tax while retaining its broad corporate retirement
plans.
House solution. — The House bill provides limitations, similar to
those contained in H.R. 10, with respect to contributions made by sub-
chapter S corporations to the retirement plans for those individuals
who are "shareholder-employees," defined as employees or officers who
own more than 5 percent of the corporation's stock. Under the bill, a
shareholder-employee must include in his income the contributions
made by the corporation under a qualified plan on his behalf to the
extent contributions exceed 10 percent of his salary or $2,500, which-
ever is less. This provision applies to taxable years of subchapter S
corporations beginning after 1969.
Argument For. — If an enterprise wants to incorporate for business
purposes, but wants to be taxed in a manner similar to a partnership,
then it should be subject to the same H.R. 10 limitations as partnerships
in the case of pension plan contributions it makes on behalf of its
owner-employees.
Arguments Against. — (1) Subchapter S corporations are in fact
corporations; the subchapter S election doesn't entitle them to part-
nership taxation but rather to tax treatment in a manner similar to
the partnership rules, and these special rules do not provide all the
benefits of partnership taxation.
(2) H.R. 10 limitations are too restrictive and should be revised in
a more reasonable manner possibly on a comparable basis with the
corporate plans.
(3) The process of revising all the existing plans presents an unbear-
able burden.
(4) This change in the law should await a Congressional review of
95
the overall treatment of pension plan contributions and benefits, in-
cluding the Treasury Department study of 1965.
Y. TAX TREATMENT OF STATE AND MUNICIPAL BONDS ^
Present Jaio. — Interest payments on obligations of State and local
governments generally are exempt from Federal income tax, an exemp-
tion that has been provided ever since the Federal income tax was
adopted in 1913.
Problem. — The tax savings for individuals and corporations from
the purchase of tax-exempt bonds has been greater than the differential
between the interest yields on tax-exempt and taxable bonds. As a
result, it has been estimated tliat the interest savings to State and local
governments was $1.3 billion in 1968, but the tax revenue loss of the
Federal Government was $1.8 bilUon.
In addition some State and local governments have issued arbitrage
bonds whose proceeds are invested in Treasury bonds which pay a
higher interest yield than the issuer's tax-exempt yield. The issuer
retains the differential between the interest yields as an addition to its
revenues.
House solution. — State and local governments are given the volun-
tary election to issue taxable bonds. If they make this choice, the Fed-
eral Government will pay between 25 and 40 percent of the interest on
the bond (between 30 and 40 percent through the end of 1974). The
Secretarv of the Treaury will determine and publish the percentage
for the Federal payment before the first day of each calendar quarter,
and the percentage will apply for the entire life of all taxable bonds
issued during that quarter. The Federal payments will be made under a
permanent appropriation no later than the time when the issuing
government must pay the interest on its bonds. This provision applies
to issues made in calendar quarters that begin- after the date of
enactment.
Federal income tax exemption would no longer apply to arbitrage
bonds issued after July 11, 1969.
Arguments For. — (1) The election to issue taxable bonds is volun-
tary on the part of S^ate and local flrovernments, and the Federal Gov-
ernment automatically makes the interest payments if they so elect.
Since this provision is voluntary on the part of States and local govern-
ments none need elect it unless it works to their advantage.
(2) The Federal Government will have no powers of review over the
purpose for which the bonds are issued or the capacitv of the issuing
government to repay its debt and, as a result, there will be no Federal
control of the program.
(3) Because of the higher yield on the taxable bonds, the market for
State and local bonds will be broadened.
(4) The Federal subsidv provided by the bill will be offset — possibly
more than offset — by increased taxes as the portion of the interest on
the bond paid by State municipal governments moves from nontaxable
to taxable status.
(5) The provision would help eliminate the stimulus present tax
exemption exerts on wealthy individuals to purchase State and local
government obligations for tax reasons, thereby diverting their in-
vestments from areas more economically justified.
1 See also discussion under Limit on Cax Preferences, page 47, and Allocation of Deduc-
tions, page 48.
96
Arguments Against. — (1) The provision opens the way to complete
repeal of the State and local tax exemption.
(2) It does not avoid the constitutional question as to whether Con-
gress has the power to tax the income from State and local obligations;
if the Constitution prohibits the Federal Government from taxing
these obligations the Constitution cannot be made inapplicable at the
election of a State or municipal government. The provision is a fur-
ther incursion of the Federal Government into the affaii-s of State and
local governments and in this respect it runs counter to the goal of
decentralized government.
(3) It is argued that commercial banks which are the most signifi-
cant purchasers of tax-exempt bonds may reduce their purchases
when the issues are taxable in light of other provisions in the bill that
increase the effective rate of taxation on commercial bank net income.
Z. EXTENSION OF TAX SURCHARGE AND EXCISE
TAXES; TERMINATION OF INVESTMENT CREDIT
1. Extension of Tax Surcharge at 5-Percent Annual Rate for
First Half of 1970.
Present laio. — The Revenue and Expenditure Control Act of 1968
adopted a 10-percent surcharge on the tax liabilities of individuals
and business corporations in order to dampen inflationary pressures
and keep the economy under control. The 10-percent surcharge expired
as of June 30, 1969. H.R. 9951 extended the 10-percent surcharge for
the period from July 1, 1969, through December 31, 1969.
Prohlein. — The extension of the surcharge until the end of calendar
year 1969 provided by H.R. 9951 will help combat the inflationary
pressures which are rampant in the economy. However, these infla-
tionary pressures are now so strong that some extension of the sur-
charge through the first half of 1970 may be necessary in order to
finish the job of bringing the economy under control. The gross
national product is still rising sharply, the consumer price index and
the wholesale price index have risen at an annual rate of over 6-per-
cent since the end of last year and our financial and money markets
are showing marked signs of strain.
House solution. — The House bill provides that the surcharge on the
tax liabilities of individuals and corporations which, under H.R. 9951,
is scheduled to expire on December 31, 1969, shall be continued at a
5-percent annual rate for the period from January 1, 1970, until June
30, 1970. Since this 5-percent surcharge will be applicable only for the
first half of 1970, the surcharge for the entire year 1970 will be 2%-
percent for a calendar-year taxpayer.
Note. — This provision was included in H.R. 1:2290, the bill to repeal
the 7 percent investment tax credit, to extend the 10 percent income
tax surcharge, and for other purposes. It was a,pproved by the Com-
mittee on Finance when the Committee ordered that bill reported in
July. For that reason no position for or against it is stated.
2. Continuation of Excise Taxes on Communication Services and
Automobiles
Present law. — The excise tax on passenger automobiles presently is
7 percent and the excise tax on local and toll telephone services and
teletypewriter exchange services presently is 10 percent. Both rates
97
are scheduled to decline to 5 percent on January 1, 1970, 3 percent on
January 1, 1971, 1 percent on January 1, 1972, and to be repealed on
January 1, 1973.
Problem. — It appears inappropriate to reduce these excise taxes
during a period of serious inflationary pressures when the Federal
Government has imposed an income tax surcharge and is applying
other forms of fiscal and monetary restraints to control the inflationary
pressures.
House solution. — The scheduled reductions which were to begin on
January 1, 1970, are delayed for 1 year. As a result, the 5 percent
excise tax rates will become effective on January 1, 1971, the 3 percent
rate on January 1, 1972, and the 1 percent rate on January 1, 1973, and
the repeal of these excise taxes will take effect on January 1, 1974.
Note. — This provision was included in H.R. 12290, the bill to repeal
the 7 percent investment tax credit, to extend the 10 percent income
tax surcharge, and for other purposes. It was approved by the Com-
mittee on Finance when the Committee ordered that bill reported in
July. For that reason no position for or against it is stated.
3. Repeal of the Investment Credit
Present law. — Present law provides a 7-percent tax credit (3 per-
cent for public utility property) for qualified investment in : (1) tangi-
ble personal property; (2) other j)roperty (not including buildings
and structural components) which is an integral part of manufactur-
ing or production, or a research or storage facility; and (3) elevators
and escalators.
To qualify, the property must be depreciable and have a useful life
of four years or more. New property fully qualifies for the credit. Up
to $50,000 of used property can be taken into account in any year.
Property with a useful life of from four to six years (][ualifies for
the credit to the extent of one-third of its cost. Property with a useful
life of six to eight years, qualifies to the extent of two-thirds of the
investment. If the property has a useful life of eight years or more,
the full amount qualifies.
The amount of the investment credit taken in any year may not
exceed the first $25,000 of tax liability plus 50 percent of the tax lia-
bility in excess of $25,000. Investment credits which, because of this
limitation, cannot be used in the current year may be carried back to
the three prior years and carried forward to the succeeding 7 taxable
years.
Problem. — The investment credit does not appear to be suited to
present conditions. The credit was designed to provide a tax induce-
ment for businessmen to modernize their equipment and expand pro-
ductive capacity. Since 1962, business has invested almost $400 billion
in new plant and equipment, and it would appear that there is no
reason to grant a tax inducep^ent for new investment now.
The current outlook is that plant and equipment expenditures will
reach record levels in 1969. Tlie most recent Commerce Department —
SEC survey indicates that such expenditures will reach $72.2 billion in
1969 — 12.5 percent more than was spent for this purpose in 1968. Much
of this investment results from the present inflationary psychology
which induces businessmen to increase plant and equipment spending
beyond normal levels in an attempt to avoid higher costs in later years.
98
In such a situation, business investment should not be stimulated.
Instead, such investment should be moderated in order to contain an
overactive economy and reduce inflationary pressures.
The investment credit cannot be turned on and off quickly to adjust
to current economic conditions. In 1966, the credit was suspended
temporarily in order to reduce the inflationary impact of large invest-
ment expenditures; but the investment credit continued to have an
expansionary impact on some investments beyond the cutoff date as
a result of transition provisions and carrj^overs of unused credits. In
other cases, there was distortion in the investment process because
businessmen postponed normal investments in anticipation of the time
when the credit would be restored.
House solution. — The House bill provides for the permanent repeal
of the investment credit in the case of property acquired, or the con-
struction of which is begun, after April 18, 1969. The bill also provides
an exception to this general rule under which the credit is to continue
to be available for property constructed or acquired under a binding
contract entered into before April 19, 1969. A number of other transi-
tion rules are also provided by the bill under which the credit will
continue to be available in situations where, although a binding con-
tract is not involved, a substantial portion of the property in question
had been acquired, constructed, or contracted for prior to April 19,
1969. The transition rules in the bill are generally the same as those
provided in the legislation which temporarily suspended the invest-
ment credit in 1966.
The bill also provides for the "phaseout" of the investment credit
in the case of property placed in service after 1970 (which generally
would be eligible for the credit under a transition rule) . Under this
"phaseout," the credit is to be reduced by one-tenth of one percentage
point for each full calendar month after November 1970 and the date
the property is placed in service. In addition, no credit will be allow-
able for property placed in service after 1974.
The bill also places a limit on the extent to which taxpayers may
carry over unused investment credits to 1969 and subsequent years. As
of the end of 1968 these unused investment credits amounted to an
estimated $2 billion. Under the limitation provided by the bill, the
credit taken in a year after 1968, attributable to carryovers, cannot
exceed 20 percent of the aggregate amount of unused investment credits
otherwise available as carryovers to the year in question (or to any
prior year after 1968 if the carryovers to that year are higher than
in the current year) . This limitation is in addition to the general 50
percent of the tax liability limitation on the amount of credit which
may be claimed in a year. The bill also retains the present length of
the carryover periods (3 years back and 7 years forward).
Note. — This provision was included in H.R. 12290, the bill to repeal
the 7 percent investment tax credit, to extend the 10 percent income
tax surcharge, and for other purposes. It was approved by the Com-
mittee on Finance when the Committee ordered that bill reported in
July. For that reason no position for or against it is stated.
4. Amortization of Pollution Control Facilities
Present laio. — Under present law, a taxpayer may claim an invest-
ment credit with respect to pollution control facilities to the extent
99
they involve property of a type generally eligible for the investment
credit.
Prohlem. — There is a present need for industry to install facilities
that will remove pollutants and contaminants from air and water
discharged after use in production processes. Since termination of the
investment credit will remove to some extent the financial offsets to the
costs of these facilities, an alternative form of incentive may be viewed
as desirable.
House solution. — The bill- provides that a taxpayer will be allowed
to amortize over a period of 60 months any new certified air or water
pollution control facility that is identifiable as a separate treatment
facility. The amortization deduction Avould be taken in place of the
regular depreciation deduction. The amortization deduction generally
would be available only for a pollution control facility that is con-
structed after 1965 and that is certified by the appropriate State and
Federal Authorities as being in conformity with relevant programs
and requirements for the abatement or control of air or water pollu-
tion. The amortization is to be available for taxable years ending after
1968.
Note. — This provision was included in H.E. 12290, the bill to repeal
the 7 percent investment tax credit, to extend the 10 percent income
tax surcharge, and for other purposes. It was approved by the Com-
mittee on Fmance when the Committee ordered that bill reported in
July. For that reason no position for or against it is stated.
5. Amortization of Certain Railroad Rolling Stock
Present law. — A taxpayer may claim an investment credit with re-
spect to railroad rolling stock to the extent they are property of a
type for which the investment credit generally is available. Under
present depreciation guidelines, the useful life of rolling stock is
14 years.
Prohlem. — The railroad industry generally has been in poor finan-
cial condition for many years. The investment credit made a substan-
tial contribution to the modernization of railroad equipment and in
increasing railroad efficiency by improving the ability of the railroads
to finance the acquisition of new equipment.
House solution. — Domestic common carrier railroads subject to
regulation by the Interstate Commerce Commission may elect to amor-
tize all railroad rolling stock (except locomotives) over a period of 84
months. (The bill erroneously provides for 7-year depreciation, in-
stead of amortization). The provision applies to eligible rolling stock
that is constructed or acquired and put into original use after July 31,
1969.
Arguments For. — (1) Amortization is an appropriate incentive be-
cause it permits a rapid recovery of the costs involved and does not
extend a return in excess of actual total costs.
(2) Amortization is preferable to accelerated depreciation because
it permits a complete write-off of the equipment without adjustment
for salvage value.
(3) Amortization is preferable to depreciation because it does not
entail adjustment for the restrictions required by the "reserve ratio
test" in the depreciation guidelines.
33-158 O— 69-
100
(4) On the other hand, the amortization provision does not extend
to companies which purchased railroad rolhng stock eligible for the
investment credit and leased the equipment to railroads.
(5) Since it appears the 7-percent investment tax credit will be
repealed without industry exemptions, some other form of stimulus —
such as amortization — must replace it or the railroads will be unable
to attract capital needed to modernize and expand their rolling stock.
Argiiments Against. — (1) Repealing the 7-percent investment tax
credit and replacing it with amortization is just substituting one tax
preference for another.
(2) If there is freight to be hauled, the profit motive is all the
incentive needed to assure that the necessary rolling stock will be
acquired.
(3) The depreciation practices of the railroad industry are already
among the most complex of any industry, and this provision com-
pounds the complexity without adding greatly to the cash flow they
presently can generate through accelerated depreciation.
AA. ADJUSTMENT OF TAX BURDEN FOR
INDIVIDUALS
1. Increase in Standard Deduction
Present law. — Under present law, a taxpayer in computing taxable
income may itemize his deductions, or may take the larger of the
minimum standard deduction or the 10 percent standard deduction.
The minimum standard deduction is $200 plus $100 for each exemption,
and the regular standard deduction is 10 percent of adjusted gross
income. Both forms of the standard deduction are limited to $1,000
($500 in the case of a married individual filing a separate return) .
Problem. — The 10 percent standard deduction was introduced in
1944 to reduce the complexity of the income tax for the vast majority
of taxpayers. Instead of keeping records of deductible personal ex-
penditures and itemizing deductions on their tax returns more than
82 percent of taxpayers were able to use the simpler standard deduction
when it was first introduced. Since that time, higher medical costs,
higher interest rates, higher State and local taxes, increased home-
ownership, and more expensive homes have encouraged more and more
taxpayers to itemize their deductions. In addition, itemization has been
encouraged by rising incomes which have moved more and more
taxpayers beyond the $10,000 income level where the $1^000 standard
deduction ceiling first becomes applicable. The effect of higher incomes
and increased expenses has been to decrease the proportion of returns
using the standard deduction from 82 to 58 percent.
House solution. — The House bill increases the 10-percent standard
deduction and $1,000 ceiling to 15 percent with a $2,000 ceiling in three
stages : in 1970 to 13 percent with a $1,400 ceiling, in 1971 to 14 per-
cent with a $1,700 ceiling, and in 1972 to 15 percent with a $2,000
ceiling. The increase was made in three stages to avoid an excessive
revenue loss in 1970 and 1971.
Arguments For. — (1) The 15-percent standard deduction with
a $2,000 ceiling will result in substantial simplification. This com-
bined with the $1,100 low-income allowance also contained in the bill
will cause a total of 11.8 million or 37 percent of all itemizers to
101
switch to the standard deduction. The proportion of returns using the
standard deduction as a result of the low-income allowance and the
higher standard deduction taken together will be nearly 74 percent.
(2) This higher standard deduction also will provide a tax reduction
to a substantial number of taxpayers. By itself, the 15 percent, with a
$2,000 ceiling will reduce taxes by $2.4 billion for 33.7 million returns
or more than 53 percent of taxable returns. After the low-income
allowance of $1,100, it will provide a tax reduction of $1,4 billion for
approximately 16.7 million returns or 29 percent of the returns which
remain taxable after the low-income allow^ance.
(3) In 1944, when the standard deduction was first added to the tax
law, 82.2% of the individual tax returns filed used the standard deduc-
tion in lieu of itemizing. However, by 1965 only 58.8% of the returns
filed used this deduction. The bill will help to restore the use of the
standard deduction to the 1944 levels.
(4) The provision will reduce the number of income tax returns
which will need to be audited by the Internal Revenue Service.
Arguments Against. — (1) If the standard deduction is liberalized,
tax incentives for making contributions to charity will be reduced for
many taxpayers.
(2) The standard deduction permits two taxpayers, in the same
.family circumstances and with the same adjusted gross income, to pay
the same tax even though these two taxpayers incur substantially dif-
ferent amounts of itemizable expenses. Raising the standard deduc-
tion will, of course, increase this inequity.
(3) Other provisions of the bill provide rate reductions to all indi-
vidual taxpayers. The increase in the amount of the standard deduc-
tion will, in effect, provide additional reduction of tax liability to many
of the same individuals and amounts to a doubling of tax benefits.
(4) The 15-percent standard deduction with a $2,000 ceiling in-
volves too great a revenue loss. Furthermore, it is noted that the
doubling of the ceiling (from $1,000 to $2,000) provides larger per-
centage tax decreases to taxpayers in the $10,000 to $15,000 income
range than to any other group.
2. Low-Income Allowance
Present law. — The minimum standard deduction is $200 plus $100
for each personal exemption up to a total of $1,000.
Problem. — Inflationary price increases have had their most severe
impact in the erosion of the already inadequate purchasing power of
the poor. In addition, recent studies of the economic conditions of the
poor by the Department of Health, Education, and Welfare have in-
dicated, even with the present minimum standard deduction, many
persons with incomes below the poverty level are subject to tax and,
in addition, substantial tax burdens are imposed on those with incomes
immediately above the poverty levels.
House soiutio7i. — The bill replaces the minimum standard deduction
with a low income allowance of $1,100 for each taxpayer. The level of
taxation for each taxpayer, thus, will begin where adjusted gross in-
come exceeds the $1,100 low income allowance plus the number of per-
sonal exemptions the taxpayer may claim. The low income allowance
will be available for 1970 and later years.
102
In 1970 only, the bill provides a phaseout of the low income allow-
ance (to the extent it exceeds the present minimum standard deduc-
tion). This excess is to be reduced by $1 for each $2 that the taxpayer's
adjusted gross income exceeds the nontaxable income level. The phase-
out is repealed after calendar year 1970.
Note. — This provision was included in H.R. 12290, the bill Ito repeal
the 7 percent investment tax credit, to extend the 10 percent income
tax surcharge, land for other purposes. It was approved by the Com-
mittee on Finance when the Committee ordered that bill reported in
July. For that reason no position for or against it is stated.
However it is observed that the phaseout of the low-income allow-
ance is deleted with respect to years after 1970, raising the cost of the
allowance by $2 billion.
3. Maximum Tax on Earned Income
Present law. — Under present law, the individual income tax rates
reach a maximum of 70 percent for taxable income in excess of $100,-
000 for single persons and $200,000 for joint returns. The 70 percent
rate is applicable to all taxable income other than capital gains sub-
ject to the alternative rate of 25 percent.
Problem. — The present tax rates with a maximum of 70 percent
seem unrealistically hi^h especially in the case of earned income. They
appear to have some disincentive effect and motivate taxpayers to use
and develop methods of tax avoidance. The high rates are, in part, re-
sponsible for attempts to shelter income from tax and for the diver-
sion of consideralble time, talent, and effort into "tax planning"' rather
than economically productive activities. The high rates also take what
can be considered an excessive portion of the income of those who are
unable to shelter their earned income from the full impact of these
rates.
House solution. — The House-passed bill provides that the maximum
marginal tax rate applicable to an individual's earned income is not
to exceed 50 percent. This is, in effect, an alternative tax computation
for earned income under which earned income in the taxable income
brackets w^here the tax rate would otherwise be greater than 50 per-
cent is subject to a flat 50 percent rate.
Argument For. — (1) While it is not feasible to reduce the tax rates
in excess of 50 percent to 50 percent for all types of income at the
present time because of the revenue cost, a reduction in the tax rates
applicable to earned income to a maximum of 50 percent should sub-
stantially reduce the pressure to use and develop tax loopholes. Since
the disincentive effect of liigh tax rates on effort is greatest in the case
of earnings, it is most efficient to focus the 50 percent limit on earned
income.
(2) High tax rates on earned income (wages, salaries, and fees)
reduces personal initiative 'because the high bracket taxpayer receives
only a small marginal amount of "after tax" income for any addi-
tional work.
Arguments Against. — (1) This provision is a "loophole for those
persons without loopholes." The income tax base should be broadened
with the rates on that tax base made substantially lower.
(2) There is no reason for lowering the tax rate if the "ability to
pay" theory of a progressively graduated income tax structure is
accepted.
103
(3) The main objection to the maximum rate of 50 percent on earned
income is that it limits the top rate of 50 percent to one type of income
instead of making rate reduction generally applicable. For example,
instead of a 65 percent top rate for unearned income and a 50 percent
top rate for earned income it might be argued that it would be prefer-
able to make the top rate 60 percent for all types of income.
4. Intermediate Tax Rates: Surviving Spouse Treatment
Present law. — Since the Revenue Act of 1948, married couples filing
joint returns have had the option of being taxed under the split-income
provision. This, in effect, taxes a married couple as if it were composed
of two single indi\aduals each with one-half the couple's combined
income. This 50-50 split of income between the spouses for tax pur-
poses generally produces a lower tax than any other division of income
since the application of the graduated tax rates separately to eacfi of
the two equal parts comprising the couple's income keeps the total
income in lower tax brackets.
Single people generally do not have a comparable income splitting-
privilege. As a result they pay liigher taxes than married couples at
the same income levels.
In 1951, a head-of-household provision was enacted to grant partial
income-splitting to widows, widowers, and single persons with depend-
ents in their households. Individuals who qualify under this provision
are allowed approximately one-half of the income-splitting benefits
given to married couples. These heads of household use a different tax
rate schedule which, at any given level of income, produces a tax lia-
bility about halfway between the tax paid by a married couple filing
a joint return and a single individual.
Beginning in 1954 surviving spouses with dependent children were
permitted to use the joint return tax rates with full income splitting
for two taxable years following the year of death of the husband or
wife.
Problem. — Widows, widowers, and unmarried individuals who
do not support dependents in a household cannot qualify for head-of-
household treatment under present law. As a result, such individuals
are taxed as single individuals and do not receive the income-splitting
benefits accorded to heads of households (that is, one-half the income-
splitting benefits granted to married couples filing joint returns). It
is argued that this treatment places unduly heavy tax burdens on
mature single individuals, widows and widowers. Such individuals
more often than not have to incur the expense of maintaining a house-
hold; and in any event, it is maintained, they should receive some
income splitting in order to be treated fairly compared with married
couples. Moreover, for widows and widowers present law is said to
be harsh in that it withdraws all the benefits of income splitting after
their spouse dies despite the fact that they may continue to have
relatively heavy living expenses.
House solution.— The House bill extends the benefits of income
splitting to specified groups of individuals whose taxes are deemed to
be too heavy under present law.
104
Under the bill, widows and widowers, regardless of age, and un-
married individuals age 35 and over are to be taxed at rates which
are halfway between the rates available to married couples and those
previously available to single persons. This intermediate tax rate
treatment was formerly known as head-of-household treatment. This
provision applies to years beginning after 1970.
The bill also provides that a widow, or widower, with a dependent
child in the household is to receive the full income splitting benefits
available to married couples for as long as she or he continues to sup-
port the child in her or his household and is entitled to a dependency
exemption for the child (rather than just two years after the person's
spouse has died as at present). Generally, this treatment will be avail-
able where the child is age 19 or less or is attending school or college.
This provision applies to years beginning after 1969.
Arguments For. — (1) The House provision extends relief to large
numbers of mature single individuals and surviving spouses whose
taxes are now relatively heavy compared with those paid by married
couples at the same income levels. This is favored by those who gen-
erally believe that the split-income provision grants excessive tax re-
ductions to married couples and places too heavy burdens on single
people generally.
(2) Surviving spouses with a dependent child continue to have the
full obligations of a married couple toward their children after their
spouses die. Therefore, they should continue to receive full income-
splitting.
Arguments Against. — ( 1 ) The selection of age 35 as the age at which
individuals should receive a more favorable tax treatment is arbitrary.
Many single individuals, of that age or older, with considerably dif-
ferent economic situations will be receiving the same tax treatment
while those of slightly different ages but similar incomes will be taxed
differently.
(2) A more favorable result for the Treasury — but one producing
equity for single persons — would be reached if income splitting for
married taxpayers were repealed instead of extending split income
tax relief to certain single individuals.
(3) The provision is adverse to marriage because two individuals
eligible for the intermediate tax rates (which confer one-half the full
income-splitting benefits accorded married couples) could find their
combined tax liabilities increased as a result of marriage. However,
there is some question whether marriage is significantly affected by
such tax considerations.
5. Individual Income Tax Rates
Present law. — Present law tax rates range from 14 percent to 70
percent on taxable income in excess of $100,000 for a single taxpayer
and $200,00 for a joint return (see the rate schedule, p. 105) .
Problem. — The present tax rates are considered by many to be too
high. They take an excessive portion of the income from those subject
to the full impact of the rates. Such high rates also encourage many
taxpayers to shelter their income from the top rates by using tax
avoidance techniques which have frequently developed into tax
loopholes.
House solution. — The House bill reduces all tax rates by at least
one percentage point and reduces the top bracket rate from 70 percent
to 65 percent. In all brackets this is a tax reduction of 5 percent or
more. The reduction is to take place in two stages because of the
105
revenue loss: half in 1971, and the full reduction in 1972. (See the
rate schedule below) .
INDIVIDUAL INCOME TAX RATE SCHEDULE UNDER PRESENT LAW AND UNDER H.R. 13270 FOR CALENDAR YEARS
1971 AND 1972
Taxable income bracket
Tax rate (percent)
Single person not eligible for
ntermediate rates Married (Joint)
House bill
1971 1972
r000to$500... $000 to $1,000
$500 to $1,000 $1,000 to $2,000
$1,000 to $1,500 $2,000 to $3,000
$1,500 to $2,000 - $3,000 to $4,000
$2,000 to $4,000 $4,000 to $8,000
$4,000 to $5,000 $8,000 to $12,000
$6,000 to $8,000 -- $12,000 to $16,000...
$8,000 t3 $10,000... $16,000 to $20,000...
$10,000 to $12,000 - $20,000 to $24,000...
$12,000 to $14,000 $24,000 to $28,000...
$14,000 to $16,000 $28,000 to $32,000...
$16,000 to $18,000 $32,000 to $36,000...
$18,000 to $20,000 $36,000 to $40,000...
$20,000 to $22,000 $40,000 to $44,000...
$22,000 to $26,000 .._ $44,000 to $52,000...
$26,000 to $32,000 $52,000 to $64,000...
$32,000 to $38,000 - $64,000 fo $76,000...
$38,000 to $44,000.... $76,000 to $88,000...
$44,000 to $50,000 - $88,000 to $100,000..
$50,000 to $60,000... $100,000 to $120,000.
$60,000 to $70,000 $120,000 to $140,000.
$70,000 to $80,000 $140,000 to $160,000.
$80,000 to $90,000 $160,000 to $180,000.
$90,000 to $100,000 -. $180,000 to $200,000.
$100,000 to $120,000 _ -.- $200,000 to $240,000.
$120,000 to $150,000.-.. $240,000 to $300,000.
$1 50,000 to $200,000 $300,000 to $400,000.
$200,000 and over $400,000 and over...
14
15
16
17
19
22
25
28
32
36
39
42
45.
48
50
53
55
58
60
62
64
66
68
69
70
70
70
70
13.5
14.5
15.5
16.5
18.5
21.5
24
27.5
31
35
38
41
43.5
46
48.5
51
52.5
55
57
60
62
63
64.5
65
66
66.5
67
67.5
13
14
15
16
18
21
23
27
30
34
37
40
42
44
47
49
50
52
54
58
60
60
61
61
62
63
64
65
Arguments For. — (1) It is appropriate to redistribute the tax
burden by closing loopholes and eliminating preferences on the one
hand, and lowering tax rates on the other.
(2) Tax reduction is justified on the grounds that present rates are
unrealistic and have been instrumental in encouraging the develop-
ment of tax avoidance devices and tax shelters. Lower tax rates reduce
the incentive to use and devise methods of avoiding tax and reduce the
disproportionate influence of tax considerations on economic decisions,
lx)th socially desirable goals.
Arguments Against. — (1) Tax rates should not be reduced (even on
a prospective basis) during a period when inflation is so strong, and
further extension of the income tax surcharge is being considered to
combat it.
(2) One objection to the reduction of all tax rates is that the revenue
cost is $4.5 billion. This amount unbalances the reform and relief
program in contrast to the rate schedule in the bill as rej^orted by the
Ways and Means Committee. That rate schedule roughly balanced
the revenue gain from tax reform and the revenue loss from tax relief.
6. Collection of Income Tax at Source on Wages
Present law. — Present law provides withliolding tables and a per-
centage withholding method which incorporates the $600 personal
exemption, the minimum standard deduction, the 10 percent standard
deduction, and the tax rates.
House soJution. — The withholding rates and tables incorporate the
changes made in the minimum standard deduction (the low income
allowance), the 10 percent standard deduction, and the tax rates.
PART 3
STATISTICAL MATERIAI^TABLES
(107)
PART 3
STATISTICAL MATERIAL— TABLES
TABLE 1.— THE BALANCING OF TAX REFORM WITH TAX RELIEF UNDER H.R. 13270 WITH MODIFIED
RATE REDUCTION— CALENDAR YEAR TAX LIABILITY
|ln millions of dollars]
1970 1971 1972 1974 1979
Tax reform program -. +1,640 +2,050 +2,180 +2,600 +3,555
Repeal of investment credit +2,500 +3,000 +3,000 +3,100 +3,300
Tax reform and repeal of investment credit.. +4,140 +5,050 +5,180 +5,700 +6,855
Income tax relief -1,692 -6,787 -9,273 -9,273 -9,273
Note: The tax surcfiarge extension ($3,100,000,000 liability for 1970) and the excise tax extension ($1, 170,000,000'
$800,000,000, $800,000,000, and $400,000,000 for 1970 through 1973, respectively) are not included above because of their
impermanent character.
TABLE 2.-BALANCING OF TAX REFORM AND TAX RELIEF-CALENDAR YEAR TAX LIABILITY
[In millions of dollars]
1970 1971 1972 1974 1979
Tax reform program.. +1,640 +2,050 +2,180 +2,600 +3,555
Repeal of investment credit +2,500 +3,000 +3,000 +3,100 +3,300
Tax reform and repeal of investment credit.... +4,140 +5,050 +5,180 +5,700 +6,855
Income tax relief:
Low/ income allowance.. —625 —625 —625 —625 —625
Removal of phaseout on low/ income allowance —2,027 —2,027 —2,027 —2,027
Increase in standard deduction I -867 -1,086 -1,373 -1,373 -1,373
Rate reduction - -2,249 -4,498 -4,498 -4,498
Maximum 50-percent rate on earned income —200 —150 —100 —100 —100
Intermediate tax treatment for certain single
persons, etc -650 -650 -650 -650
Total reductions -1,692 -6,787 -9,273 -9,273 -9,273
1 1970: 13 percent, $1,400 ceiling; 1971 : 14 percent, $1,700 ceiling; 1972: 15 percent, $2,000 ceiling.
Note: The tax surcharge extension ($3,100,000,000 liability for 1970) and the excise tax extension ($1,170,000,000,
$800,000,000, $800,000,000 and $400,000,000, for 1970 through 1973, respectively) are not included above because of their
impermanent character.
(109)
no
TABLE 3.— INDIVIDUAL INCOME TAX LIABILITY— TAX UNDER PRESENT LAW AND AMOUNT AND PERCENTAGE
OF CHANGE UNDER REFORM AND RELIEF PROVISIONS WHEN FULLY EFFECTIVE
AGI class
Tax under
present law
(millions)
Increase (+) decrease (— ),
from reform and relief pro-
visions (taking into account
committee amendment)
Amount
(millions)
Percentage
Percentage
tax decrease
under orig-
inal rate
schedule
Additional
percentage
point
reduction
from modi-
fied rate
scliedule
$0 to $3,000 $1,169 -$775 -66.3 -64.0
$3,000 to $5,000 3,320 -1,049 -31.6 -27.3
$5,000 to $7,000 5,591 -996 -17.8 -12.3
$7,000 to $10,000 11,792 -1,349 -11.4 -6.5
$10,000 to $15,000 18,494 -1,932 -10.4 -6.0
$15,000 to $20,000... 9,184 -775 -8.4 -5.4
$20,000 to $50,000 13,988 -976 -7.0 -5.1
$50,000 to $100,000... _._. 6,659 -365 -5.5 -5.0
$100,000 and over 7,686 +324 +4.2 +4.2
Total _. 77,884 -7,893 -10.1 -7.0
2.3
4.3
5.5
4.9
4.4
3.0
1.9
.5
3.1
TABLE 4.— TAX RELIEF PROVISIONS AFFECTING INDIVIDUALS AND TOTAL FOR ALL REFORM AND RELIEF PRO-
VISIONS AFFECTING INDIVIDUALS, WHEN FULLY EFFECTIVE, BY ADJUSTED GROSS INCOME CLASS, 1969 LEVELS
[In millions of dollars]
15-
percent
Maxi-
Inter-
Low
$2,000
mum
mediate
Total
Reform
income
Elimi-
standard
General
tax on
tax
relief
Total,
pro-
allow-
nation of
deduc-
rate re-
earned
treat-
pro-
all pro-
AGI class
visions
ance
phaseout
tion
ductions
income
ment
visions
visions
0 to $3,000
+16
-3
-552
-72
-202 .
-788
-27 .
-141 .
-10
-45
-791
-1,046
-775
$3,000 to $5,000
-1,049
$5,000 to $7,000
+3
-1
-594 .
-329 .
-75
-999
-996
$7,000 to $10,000....
+7
-335
-228
-663 .
-130
-1,356
-1,349
$10,000 to $15,000...
+26
-83
-789
-975 .
-111
-1,958
-1,932
$15,000 to $20,000...
+23
-16
-231
-496 .
-55
-798
-775
$20,000 to $50,000...
+90
-8
-117
-806 _
-135
-1,066
-976
$50,000 to $100,000..
+137
-1
-7
-420
-20
-54
-502
-365
$100,000 and over
+1,081
+1, 380
-1
-1,373
-641
-80
-35
-757
+324
-625
-2,027
Total
-4,498
-100
-650
-9,273
-7,893
Ill
3' *» a>
Q.<D «> Q.^5
^ Sc <"i.S
£ » 3.2
P o
00 O
— < </)
< C
= .2
a =
> '1
O c
11 "I I
<■— 00=3
CM
■- 0-S.9
O =
^, £ <« f o ^
o 2 M=>*- o
~ 5 X = E
UJ~S ° 5;
+
;^.— I CNJ CO ro r^ o» ir>
■^irs C3 O IT) o o
++++++
»^^^mroCT>c3 ,— icM j;
s_i ^ CO CO CO r». o)
+++
+"
-CSC
Lr>como>inoocD«*^
,S^i^1
tr^k^M-fe^k
112
TABLE 6.— REVENUE ESTIMATES, TAX REFORM, CALENDAR YEAR LIABILITY!
(In millions of dollars]
1970
1971
1972
1974
1979
Corporate capital gams 175 175 175 75 175
Foundations— Investment Income tax 65 70 75 85 100
Unrelated business income 5 5 5 5 20
Contributions 5 lo 20 20 20
Farm losses. (2) 5 10 10 20
Moving expenses -100 -100 -100 -100 -100
Railroad depreciation (2) —5 _20 —70 —100
Amortization of air and w/ater pollution —40 —130 —230 —380 —400
Corporate mergers, etc 10 20 25 40 70
Multiple corporations _ 20 45 75 135 235
Accumulation trusts 50 70 70 70 70
Income averaging -300 -300 -300 —300 -300
Deferred compensations:
Restricted stock.. (2) (2) (2) (j) (2)
Other deferred compensation (s) (2) 5 10 25
Stock dividends (2) (2) (2) (2) (s)
Subchapters (2) (2) (2) (2) (»)
Tax-free dividends 80 80
Financial institutions:
Commercial banks:
Reserve 250 250 250 250 250
Capital gain 50 50 50 50 50
Mutual thrift:
Reserve— savings and loan associations 10 25 35 60 125
Mutual (2) 5 10 J5 35
Municipals _ (2) (2) (2) (2) (2)
Capital gains:
Capital loss provisions 50 50 55 60 65
6 months-1 year holding 100 150 150 150 150
Pension plans (2) 5 10 25 50
Casualty loss (2) (2) (2) (2) (2)
Sale of papers (2) (2) (2) (2) (2)
Lifeestates 10 10 10 10 10
Franchises (2) (2) (2) (2) (2)
Removal of alternate rate 360 360 360 360 360
Natural resources:
Production payment - 100 110 125 150 200
Cut percentage depletion 400 400 400 400 400
Foreign depletion 3 25 10 (2) (2) (2)
Foreign income:
Loss carryover - 35 35 35 35 35
Restriction on mineral credits.... 30 30 30 30 30
Individual interest deduction 20 20 20 20 20
Regulated utilities* 5 .,. 60 140 185 260 310
Cooperatives - (2) (2) (2) (2) (2)
Limit on tax preferences (LPT) _ 40 50 60 70 85
Allocation - 205 420 425 440 460
Real estate:
Used property.. 15 40 65 150 250
New nonhousing (2) 60 170 435 960
Capital gain, recapture 5 15 25 50 125
Rehabilitation -15 -50 -100 -200 -330
Preliminary total 1,640 2,050 2,180 2,600
Plus investment credit - 2,500 3,000 3,000 3,100
Total 4,140 5,050 5,180 5,700
3,555
3,300
6,855
1 Except as indicated these estimates are all at current levels, the time differences being solely to show the phasein.
2 Less than $2,500,000.
3 Potentially, a larger gain appears possible. The figure shown assumes this will be offset in the beginning by carryovers
of unused credits and in the later years by increased foreign taxes.
* Assumes growth.
» Excludes change to 150 percent for construction of public utilities, 1971 ,$10,000,000; 1972, $30,000,000; 1974 $50,-
000,000; and 1979, $80,000,000.
113
TABLE 7.— TAXABLE RETURNS UNDER PRESENT LAW, NUMBER MADE NONTAXABLE BY RELIEF PROVISIONS
AND NUMBER BENEFITING FROM RATE REDUCTION
[Number of returns in thousands]
AGI class
Taxable under
present law
Made nontaxable
by low-income
allowance
and 15 percent
$2,000 standard
deduction
Remaining
taxable— benefit
from modified
rate reduction
0 to $3,000
$3,000 to $5,000
$5,000 to $7,000....
$7,000 to $10,000...
$10,000 to $15,000-.
$15,000 to $20,000..
$20,000 to $50,000..
$50,000 to $100,000.
$100,000 and over..
Total
10,053 5,398 4,655
9, 562 389 9, 173
9, 779 41 9, 738
13,815 8 13,807
13,062 7 13,055
3, 852 2 3, 850
2,594 2,594
340 -. 340
95 95
63,152
5,845
57,307
TABLE 8.— TAX BURDENS UNDER PRESENT LAW,> UNDER H.R. 13270,2 AND PERCENT TAX CHANGE
(ASSUMES NONBUSINESS DEDUCTIONS OF 10 PERCENT OF INCOME)
Married couple with
2 dependents
'djusted gross
income (wages and
salaries)
Present
tax law
H.R.
13270
tax
Percent
tax
change
$3.000 30 *0 0
$3,500 »$70 *0 -100.0
$4,000 3140 <$65 -53.6
$5,000...- '290 <200 -31.0
$7,500 5687 6576 -16.2
$10,000 - 5 1,114 6958 -14.0
Married couple with
2 dependents
Adjusted gross
income (wages and
salaries)
H.R. Percent
Present 13270 tax
tax law tax change
$12,500... 5 $1,567 6 $1,347 -14.0
$15,000 -- 5 2,062 M,846 -10.5
$17,000 ---- 5 2,598 T 2,393 -7.9
$20,000 5 3,160 '2,968 -6.1
$25,000 --.- 54,412 54,170 -5.5
' Does not include 10-percent surcharge.
2 Uses provisions effective for tax year 1972.
3 Uses minimum standard deduction of $600.
< Uses minimum standard deduction of $1,100.
5 Itemizes deductible nonbusiness expenses.
6 Uses 15-percent standard deduction.
7 Uses $2,000 limit on 15-percent standard deduction.
TABLE 9.— TAX BURDENS UNDER PRESENT LAW.i UNDER H.R. 13270,2 AND PERCENT TAX CHANGE (ASSUMES
NONBUSINESS DEDUCTIONS OF 10 PERCENT OF INCOME)
Single person under 35 (not a
widow or widower)
Adjusted gross
income (wages
and salaries)
Single person under 35 (not a
widow or widower)
Adjusted gross
income (wages
and salaries)
H R
Present 13270
tax law tax
Percent
tax
change
Present
tax law
H.R.
13270
tax
Percent
tax
change
$900
30 <0
3$115 *0
0
-100.0
-45.3
-31.2
-21.9
-12.4
$10,000
... 5$i,742
$1, 507
6 2, 078
8 2,806
8 3.683
8 4,650
' 6, 566
-13.5
■$1,700
$12,500
... '2,398
-13.3
$3,000
3 329 * $180
$15,000
... '3,154
-11.0
$4,000...
5 500 i 344
$17,500
... '3,999
-7.9
$5,000
5 671 < 524
$20,000
... '4,918
-5.4
$7,500
5 1,168 6 1,023
$25,000...
... '6,982
-6.0
1 Does not include 10-percent surcharge.
2 Uses provisions effective for tax year 1972.
3 Uses minimum standard deduction of $300.
* Uses minimum standard deduction of $1,100.
5 Uses 10-percent standard deduction.
6 Uses 15-percent standard deduction.
' Itemizes deductible nonbusiness expenses.
8 Uses $2,000 limit on 15-percent standard deduction.
114
FABLE 10.-
-TAX BURDENS UNDER PRESENT LAW,> UNDER H.R. 13270,3 AND PERCENT TAX CHANGE (ASSUMES
NONBUSINESS DEDUCTIONS OF 10 PERCENT OF INCOME)
Single person, 35 and over (widow
or widower at any age)
Adjusted gross income Present H.R. 13270 Percent
(wages and salaries) tax law tax tax change
$900 30
$1,700 3$115
$3,000 3329
$4,000 '500
$5,000 «671
$7,500 5 1,168
*0
0
40
-100.0
ni75
-46.8
4 331
-33.8
4 501
-25.3
«957
-18.1
Single person, 35 and over (widow
or widower at any age)
Adjusted gross income Present H.R. 13270 Percent
(wages and salaries) tax law tax tax change
$10,000 51,742
$12,500... ?2,398
$15,000.... 73,154
$17,500.. '3,999
$20,000 '4,918
$25,000 '6,982
« 1,399
-19.7
6 1, 906
-20.5
8 2, 532
-19.7
8 3, 250
-18.7
8 4, 042
-17.8
' 5, 643
-19.2
> Does not include 10-percent surcharge.
2 Uses provisions effective for tax year 1972.
3 Uses minimum standard deduction of $300.
4 Uses minimum standard deduction of $1,100.
5 Uses 10-percent standard deduction.
< Uses 15-percent standard deduction.
' Itemizes deductible nonbusiness expenses.
3 Uses $2,000 limit on 15-percent standard deduction.
TABLE 11.— EFFECT OF H.R. 13270 ON FISCAL YEAR RECEIPTS, 1970 AND 1971
[In billions]
Fiscal
year
Fiscal
year
1970
1971
1970
1971
Tax reform provisions:
Corporation
Individual
Total, tax reform provisions...
- -f$0.4
.. +.3
.. +.7
+$1.1
+.6
+1.7
Other provisions:
Repeal of investment credit:
Corporation
1 ndividual
Total, repeal of investment credit.
Extend tax surcharge:
Corporation
Individual :..
Total, surcharge extension...
Extend excise taxes
+$0.9
+.4
+1.3
+$1.9
+.6
+2.6
Tax relief provisions:
Corporation
Individual
-0
.. -.7
-.1
-3.6
+.3
+1.7
+2.0
+.5
+.7
+.4
+1.1
+1.1
Total, tax relief provisions
.. -.7
-3.7
Total, other provisions..
Total
+3.8
+4.8
+3.8
+2.8
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